Tracking Monetary-Fiscal Interactions Across Time and Space
CAMA Working Paper 40/2012
44 Pages Posted: 17 Jul 2013
Date Written: August 1, 2012
The fiscal position of many countries is worrying - and getting worse. Should formally independent central bankers be concerned that observed fiscal excesses spill over to monetary policy, and jeopardize price stability? To provide some insights this paper tracks the interactions between fiscal and monetary policies in the data across time and space. It makes three main contributions. The first one is methodological: we combine two recent econometric procedures - time varying parameter vector autoregression with sign restrictions identification - and discuss the advantages of this approach. The second contribution is positive: we show how monetary-fiscal interactions and other macroeconomic variables have changed over time in six industrial countries (Australia, Canada, Japan, Switzerland, the U.K., and the U.S.). The third contribution is normative: the paper highlights the role of institutional design of each policy on the outcomes of both policies. Specifically, it first offers some evidence that an explicit long-term commitment of monetary policy (a legislated numerical target for average inflation) gives the central bank stronger ground for not accommodating debt-financed fiscal shocks. Our second set of (albeit weaker) results then indicates that such threat of a policy tug-of-war may improve the government’s incentives and fiscal outcomes - reducing the probability of bot a fiscal crisis and an unpleasant monetarist arithmetic.
Keywords: Monetary-fiscal interactions, Time-varying parameters VAR, Sign restrictions, Fiscal gap, Unpleasant monetarist arithmetic
JEL Classification: E61, C10
Suggested Citation: Suggested Citation