Further Evidence on Monetary and Fiscal Policy Coordination

By Kishan, Rup.; Opiela, Timothy P. | International Advances in Economic Research, November 2000 | Go to article overview

Further Evidence on Monetary and Fiscal Policy Coordination


Kishan, Rup., Opiela, Timothy P., International Advances in Economic Research


TIMOTHY P. OPIELA [*]

The extent to which fiscal and monetary policies respond to inflation and unemployment and the degree to which policy makers coordinate their policies have important implications for their usefulness as instruments of economic stabilization. Using a framework of minimizing a policy maker's loss function, subject to the state of the economy, this paper tests for the joint determination of monetary and fiscal policies. Our results show that the pre-Reagan/Bush and pre-Volcker/Greenspan eras can be characterized by a noncooperative game between the two policies. For the Reagan/Bush and Volcker/Greenspan regimes, our results are consistent with a cooperative game in which fiscal policy dominates and monetary policy accommodates. Our results also have implications for the possibility of future cooperation by policy makers. (JEL E63, E61)

Introduction

Macroeconomic textbooks emphasize how both monetary and fiscal policies can be used to stabilize the economy. Since independent agencies conduct each policy, stabilization policy implicitly assumes there is some degree of coordination between these groups, or at least that they consider each other's policies in formulating their own. Without either assumption, only by chance will the two policies together achieve economic stabilization.

Coordination may not only be necessary, but is also a reasonable outcome of loss minimization by policy makers. An extensive literature models monetary and fiscal policies as separately engaging in games with the public in their effort to influence the economy. Since both groups affect unemployment and inflation and since each often take credit for good economic outcomes and are blamed for bad, it is reasonable to assume that a rational policy would at least consider the other policy group's actions. On the other hand, one may argue that the cumbersome nature of these decision-making bodies and the lagged responses of the two policies make coordination difficult. It is then possible that the two policies involve either a cooperative or a noncooperative game between policy makers. The existence of this game, and its outcome has important implications for the usefulness of stabilization policy and the optimal mix of fiscal and monetary policies.

Using a framework of minimizing a policy maker's loss function, subject to the state of the economy, this paper tests for the joint determination of monetary and fiscal policies. We provide evidence that past policies have been marked by either noncooperation or by accommodation of fiscal policy by the Federal Reserve (Fed). Our results have implications for the possibility of future cooperation by policy makers.

Up to now, there has been mixed evidence on whether policy has been cooperative. Bradley and Potter [1986] use a reaction function approach to test for differences in policy interaction for two periods characterized by presidential administrations: Nixon-Ford-Carter (1969:2-1981:1) and Reagan (1981:2-1984:3). Bradley and Potter include their own forecasts of inflation and unemployment and they use Ml growth as the instrument of monetary policy. They find no evidence of cooperation between the two policies in either period. During the pre-Reagan administration, a monetary policy instrument responds inversely to the fiscal policy instrument (that is, a decrease in budget surplus leads to an increase in money supply). They conclude that this indicates a noncooperative game in which the Fed accommodated fiscal policy. [1] No such accommodation was found during the Reagan administration. However, their results should be viewed with caution since their second period sample contains only nine degrees of freedom.

Nordhaus [1994] explores the interaction between monetary and fiscal policies in a vector autoregression (VAR) over the periods 1955:1 to 1994:2 and 1979:3 to 1994:2. Over the whole period, he shows that monetary policy reacts slowly to inflation and unemployment. …

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