The Impact of coordination and targets on monetary and fiscal policy

Abstract

This paper analyzes the implications of coordination of fiscal and monetary policy. We construct a differential game between a government and a central bank, which are set with the task of stabilizing the economy after an external shock. The mechanics of the game are created by assuming that the authorities must balance the cost of using their policy instruments against the cost of a slower convergence to equilibrium. We compare the competitive and cooperative equilibria under two types of shocks and when the policy makers operate under inflation targeting and output targeting respectively. The main conclusion is that policy coordination can be important for allowing the authorities to reach their targets, especially when they operate under inflation targeting.