Monetary and Fiscal Policy Coordination and Macroeconomic Stabilization. A Theoretical Analysis

Abstract

We examine the relations between monetary and fiscal policies in the process of macroeconomic stabilization. Our model suggests that each policy maker prefers to be the second mover in a "Stackelberg" situation, i.e. where one policy makers precommits its policy choice. At the same time, both Stackelberg solutions are preferable, for each policymaker, to the Nash solution. We argue that there is a natural way to choose among the two Stackelberg games, and that accordingly the government should act as the leader and adopt a fiscal policy rule based on the minimization of a loss function, which internalizes also the objective of price stability. This solution mirrors existing institutional arrangements, where fiscal policy decisions are typically taken before and less frequently than monetary policy decisions. We interpret our results in relation to the debate on monetary-fiscal coordination in EMU and on the role of the Stability and Growth Pact. We argue that a coordination mechanism along the lines of the Broad Economic Policy Guidelines is desirable.

Keywords: Monetary Policy, Fiscal Policy, Policy Coordination, EMU, Stability and Growth Pact

JEL Classification: E520, E610, E630, H700