Strategic monetary-fiscal interactions and policy outcomes

Submission note: A thesis submitted in total fulfilment of the requirements for the degree of Doctor of Philosophy to the Business School, College of Arts, Social Sciences and Commerce, La Trobe University, Bundoora.

This thesis was a recipient of the Nancy Millis Award for theses of exceptional merit.

This thesis examines strategic monetary-fiscal interactions-the game between the central bank and the government. The emphasis is on the aftermath of the 2008 global financial crisis during which policymakers faced some unprecedented challenges. This was primarily a combination of short-term threat of double-dip recession and liquidity trap combined with a long-term threat of unsustainable debt due to aging populations. The diverse monetary-fiscal policy mixes observed around the globe (ranging from large stimuli to austerity) have suggested that central bank and government may have different preferences regarding the solution of both short-term and long-term threats, and thus a policy conflict may occur. The main contribution of the thesis is to formally model the potential policy conflict and identify institutional determinants of likely monetary and fiscal regimes. Importantly, the analysis aims to formulate policy recommendations that may prevent a costly tug-of-war between central bank and government and ensure socially optimal macroeconomic outcomes. This is both in a single country setting and in a currency union such as the European monetary union, where the analysis shows free riding of small member governments makes the solution even more difficult. The thesis consists of four separate studies. The first one is empirical in nature and provides evidence of structural variation in the U.S. fiscal behaviour over time, namely a worrying recent trend away from fiscal sustainability. The subsequent three studies are game theoretic in nature. They offer novel frameworks with generalized timing of moves to capture strategic monetary-fiscal interactions more realistically. The analysis shows how the resulting monetary and fiscal policy regimes depend on various institutional and policy variables such as business cycle uncertainty, the public’s expectations, policy implementation lags and, perhaps most importantly, on the degrees of monetary and fiscal policy leadership. The beneficial role of numerical inflation targets, formal central bank independence, and enforceable fiscal rules are highlighted as well.