Fiscal-Monetary Policy Interaction

In the Richmond Fed’s Econ Focus, Eric Leeper explains his views.

  • Disparate confounding dynamics and simple policy rules:

    My view is that central banks have put far too many resources into understanding tiny fluctuations and too few resources into the things that actually matter. …

    Something like the basic Taylor rule doesn’t really serve as a useful litmus test for what policy is doing in the face of these DCDs, so it’s a little bizarre to me that a lot of central banks routinely calculate what the path of the interest rate would be with a simple Taylor rule as if that’s a useful benchmark. It’s not obvious to me what that’s a benchmark for.

  • Active/passive policy regimes, the fiscal theory of the price level and whether current or previous policy mixes are or were characterized by active fiscal policy:

    Now, how all of [current policy] ties into the active/passive framework is really an open question. A lot of it depends on what you think is going to happen to the Fed’s balance sheet.

    … the recovery from the Great Depression in 1933 when Roosevelt took the United States off the gold standard. Going off the gold standard converted government debt from effectively real debt to nominal debt because the price level under the gold standard was beyond the control of the government. At the same time, the fiscal actions Roosevelt undertook were what nowadays we would call an unbacked fiscal expansion. … This is like a fiscal rule that says the government will run deficits until the price level recovers to some pre-depression level. And the Fed was just keeping the interest rate flat. So it looked a lot like passive monetary/ active fiscal.

  • Walls between monetary and fiscal policy:

    The thing is, there’s not a lot of theoretical justification for creating these walls. What we’re finding more and more is that there’s always some role in optimal policy for using surprise inflation to revalue debt and bond prices, so long as there is some maturity to government debt. … maybe it is a slippery slope once you’re in the political realm. But from an academic perspective, if your objective is to arrive at a rule that would be mechanically followed by a central bank, then there’s no harm in having fiscal variables enter that rule.