Interactions Between Monetary and Fiscal Policy Rules*
Paper number: 99/13
Paper date: January 1999
Paper Category: Discussion Paper
University of Exeter
The Fiscal Stability Pact for EMU suggests that constraints on fiscal policy are thought by policy makers to be necessary to ensure that the independent European central bank can control inflation. In this paper we examine the interrelationship between monetary and fiscal policy when both follow simple rules. We identify two stable policy regimes. In the 'active' regime, defined as a monetary policy that seeks to raise real interest rates in response to excess inflation, a self-stabilising fiscal policy is required to ensure model stability. In the corresponding 'passive' regime, a fiscal policy which does not, by itself, ensure fiscal solvency constrains monetary policy to be relatively 'passive'. The precise nature of these constraints depends upon the importance of money and the degree to which the economy deviates from Ricardian Equivalence. We then present simulations which analyse the impact of differing degrees of policy activism in the face of shocks. Our conclusion is that the central bank does not need to seek, on this account, the degree of debt stabilisation that appears to be implied by the fiscal stability pact.
JEL Classification Nos: E50, E60
Keywords: Fiscal policy, monetary policy, simple rules, inflation targeting, fiscal theory
Corresponding Author: Campbell B. Leith, Department of Economics, University of Glasgow, Adam Smith Building, Glasgow G12 8RT, UK tel: (44) 141 330 4618, fax (44) 141 330 4940, email: C.B.Leith@exeter.ac.uk
* Draft January 1999. This research was made possible by grant L116251026 from the Economic and Social Research Council's Macro-Economic Modelling Consortium. We would like to thank Simon Price and participants at the CEPR workshop on "Current Issues in Monetary Policy", the Money, Macro and Finance Conference in London and a seminar at the University of Wales for helpful comments on an earlier draft of the paper.