Interactions between Monetary and Fiscal Policy Under Flexible Exchange Rates

34 Pages Posted: 22 Apr 2003

See all articles by Campbell Leith

Campbell Leith

University of Glasgow - Department of Economics

Simon Wren-Lewis

University of Oxford - Economics Department

Date Written: 2002

Abstract

The potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1995), under the heading of the 'Fiscal Theory of the Price Level' (FTPL). Applications of this theory to open economies operating under flexible exchange rates has suggested that, in contrast to the closed economy FTPL, insolvent fiscal policy may lead to indeterminacy of price levels and nominal exchange rates. In this paper, we relax the assumptions underpinning the FTPL by developing a two country open economy model, where each country has overlapping generations of non-Ricardian consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have independent monetary and fiscal policies. We show that the fiscal response required to ensure stability of the real debt stock, and allow each country to operate an 'active' inflation-targeting monetary policy is greater when consumers are not infinitely lived. One monetary authority can abandon its active targeting of inflation to stabilise the debt of another fiscal authority, and there is no requirement that these policy makers operate in the same economy. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when one or more monetary authority is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.

Keywords: Monetary Policy, Fiscal Policy, New Open Economy Macroeconomics, Fiscal Theory of the Price Level

JEL Classification: E10, E63

Suggested Citation

Leith, Campbell and Wren-Lewis, Simon J.Q., Interactions between Monetary and Fiscal Policy Under Flexible Exchange Rates (2002). Available at SSRN: https://ssrn.com/abstract=355040

Campbell Leith (Contact Author)

University of Glasgow - Department of Economics ( email )

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Glasgow, Scotland G12 8RT
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Simon J.Q. Wren-Lewis

University of Oxford - Economics Department ( email )

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Oxford, OX1 3BJ
United Kingdom

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