Interactions between monetary and fiscal policies

The benefits of fiscal and monetary policy coordination

In this paper, Bianchi and al. analyze a policy that involves coordination between the monetary and fiscal authorities to inflate away a fraction of the large public debt. They use a dynamic general equilibrium model  with distortionary taxation on labor and capital income. Unlike a typical model, the fiscal authority has two budgets: a regular budget, backed by future fiscal adjustments, and an emergency budget with no provisions on how it will be balanced.  The fiscal and monetary authorities agree on working together to stabilize the jump in the emergency budget as the monetary authority tolerates a temporary  increase in the inflation target.

For example, in response to COVID, the Treasury ascribes the fiscal interventions to an emergency budget. The coordinated strategy of the Fed and Treasury, against a background of record low nominal long-term interest rates and large public debt,  enhances the efficacy of the fiscal stimulus. In addition, it results in only moderate levels of inflation and preserves long-run macroeconomic stability by separating long-run fiscal sustainability from a short-run policy intervention.

We show that a coordinated action that delimits the amount of debt that requires central bank intervention may be the lesser of two evils for those concerned about preserving central [bank] independence. In fact, the coordinated strategy might be even desirable in and of itself because it would bring about a controlled reflation of the US economy, rendering the central bank the necessary room of maneuver to stabilize the economy in the years ahead.

Monetary and Fiscal Policies in Times of Large Debt: Unity is Strength
Authors: Francesco Bianchi, Renato Faccini, Leonardo Melosi
From: Duke University, Danmarks Nationalbank, Federal Reserve Bank of Chicago

Fiscal or monetary dominance?

Bassetto and Sargent argue that when monetary-fiscal policies are casted in terms of sequences of settings of monetary and fiscal policy variables, e.g., government taxes and expenditures and bonds and money supplies, government budget arithmetic asserts that, one way or another, monetary and fiscal policies must be coordinated or consolidated. On the other hand, the “fiscal theory of the price level” casts monetary-fiscal policies in terms of government strategies (i.e., sequences of functions that map time t histories into time t actions) that are sufficient to deliver a unique price level path and thereby secure a nominal anchor.

Only when we discuss theories of “nominal anchors” for a price level sequence in worlds with only fiat paper money shall we be forced to study how a polity assigns budgets and actions to separate decision makers called a treasury and a central bank.

Shotgun Wedding: Fiscal and Monetary Policy
Authors: Marco Bassetto, Thomas J. Sargent
From: Federal Reserve Bank of Minneapolis, New York University

Historical evidence

Hinterlang and Hollmayr use machine learning to identify which periods were characterized by fiscal dominance (FD) and which ones by monetary dominance (MD). They find clear evidence of FD pre-Volcker, while MD is  established between 1984 and 1988. The FD regime is further found to be in place around the stock market crash and the early 1990s recession and after the dot-com-bubble crisis in the early 2000s. The evidence for the periods thereafter is mixed with a tendency to FD after the financial crisis.

Classification of monetary and fiscal dominance regimes using machine learning techniques
Authors: Natascha Hinterlang, Josef Hollmayr
From: Deutsche Bundesbank