Welfare Improving Coordination of Fiscal and Monetary Policy

Should independent monetary and fiscal policies coordinate their actions and/or targets? To examine this question the paper considers a simple reduced-form model in which monetary and fiscal policies are formally independent, but still interdependent—through their mutual spillovers. The analysis shows that the medium-run equilibrium levels of inflation, deficit, and output depend on the two policies’ (i) potency (elasticity of output with respect to the policy instruments), (ii) ambition (the level of their output target), and (iii) conservatism (inflation vs. output volatility aversion). What matters is however the relative degrees of these characteristics across the two policies rather than the absolute degrees for each policy. This implies that coordination of monetary and fiscal policy is superior to non-cooperative Nash behaviour. In particular, we find that ambition-coordination is more important than conservatism-coordination in terms of avoiding medium-run imbalances due to a tug-of-war between the policies. For this reason, and perhaps surprisingly, ambition-coordination can be welfare improving even if the policymakers’ objectives are idiosyncratic, and their coordinated output targets differ from the socially optimal value.