Paper #949

Title:

On optimal monetary and fiscal policy interactions in open economies

Author:

Chiara Forlati

Date:

July 2004 (Revised: March 2006)

Abstract:

This paper studies monetary and fiscal policy interactions in a two country model, where taxes on firms’ sales are optimally chosen and the monetary policy is set cooperatively. It turns out that in a two country setting non-cooperative fiscal policy makers have an incentive to change taxes on sales depending on shocks realizations in order to reduce output production. Therefore whether the fiscal policy is set cooperatively or not matters for optimal monetary policy decisions. Indeed, as already shown in the literature, the cooperative monetary policy maker implements the flexible price allocation only when special conditions on the value of the distortions underlying the economy are met. However, if non-cooperative fiscal policy makers set the taxes on firms’ sales depending on shocks realizations, these conditions cannot be satisfied; conversely, when fiscal policy is cooperative, these conditions are fulfilled. We conclude that whether implementing the flexible price allocation is optimal or not depends on the fiscal policy regime.

Keywords:

Monetary and Fiscal Policy, Policy Coordination

JEL codes:

E52, E58, E62, F42

Area of Research:

Macroeconomics and International Economics

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