A comparison of monetary and fiscal policyinteracti on under ‘sound’ and ‘functional’ financ eregimes

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Mason, J. W. and Jayadev, Arjun (2018) A comparison of monetary and fiscal policyinteracti on under ‘sound’ and ‘functional’ financ eregimes. Metroeconomica, 69 (2). pp. 488-508.

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Abstract

The interest rate and the fiscal balance can be thought of as two independent instruments to be assigned to two targets,the path of output and the path of public debt. Under what we term a ‘sound finance rule’ the interest rate targets output while the fiscal balance targets public debt; under a ‘func-tional finance rule’ the budget balance targets the output gap and the interest rate targets the debt ratio. The same unique combination of interest rate and fiscal balance will be con-sistent with output at potential and a constant debt-GDPratio regardless of which instrument is assigned to which tar-get. The stability characteristics of the two rules differ,however. At low levels of debt, both rules converge to thetargets, but there is a threshold debt level above which onlythe functional finance rule converges. Contrary to conven-tional wisdom, therefore, the case for countercyclical fiscalpolicy becomes stronger, not weaker, when the ratio of pub-lic debt to GDP is already high. We apply our framework todescribe the possibility of policy-generated cycles in theUnited States over the past five decades.

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Article

Authors:

Mason, J. W. and Jayadev, Arjun

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