Monetary and fiscal policy interaction

• Applicant: Professor Dr. Alexander Kriwoluzky
• Subject Area: Economic Policy, Applied Economics
• Term: from 2014 to 2015
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 260768860

Before the financial crisis of 2008, the consensus among macroeconomists was to study monetary and fiscal policy separately. Central bank independence was generally seen as assured and monetary, not fiscal policy, was responsible for the stabilization of the economy. The global financial crisis has challenged this consensus. When the crisis grew into a sovereign debt crisis and yields on government debt rose sharply, Mario Draghi, the President of of the European Central Bank (ECB), announced that the ECB would ensure the stability of government bond markets by any means necessary. By taking government bond yields into account when making its policy decision, the ECB blurs the once clear-cut distinction between monetary and fiscal policy. Yet, not only is the central bank no longer entirely independent from the actions of the fiscal authority, fiscal stabilization policy itself has made a comeback. Recent research demonstrates that fiscal stimulus packages could be particularly effective at stimulating the economy when the main policy instrument of the central bank is stuck at the zero lower bound. These developments demonstrate that fiscal and monetary policy are intimately connected in the post-crisis world. The interaction of monetary and fiscal policy is the central focus of my proposed research agenda. I intend to study the effects of the interaction on key macro variables such as output, inflation, and public debt. The proposed research agenda has three parts: first, I investigate to what extend the inclusion of fiscal variables helps to solve a puzzling observation in monetary economics. The puzzle is that the innovations to monetary policy one obtains using the narrative approach, i.e. by studying the intentions of policy makers, are very different from the innovations one obtains estimating a standard Vector Autoregression model. The second project starts from the observation that the relationship between inflation and public deficits is time-varying. The question is whether these movements are related to the changing interaction of monetary and fiscal policy and might provide guidelines for theoretical modeling. In the third project, I plan to subject the models about the interconnectedness of monetary and fiscal policy to a real-world test. I will ask whether the policies applied in Germany during the 1930s conform to the hypothesis of unconventional fiscal and monetary policy at the zero lower bound. Germany is of special interest because since Germany had experienced a hyperinflation in 1923, the government was not able to announce that there will be higher inflation in the future. Therefore it is questionable whether the explanation, which highlights the shift in expectations, is applicable for Germany. The third project aims at finding an alternative explanation.

• DFG Programme: Research Fellowships
• International Connection: United Kingdom
• Host: Professor Dr. Morten Ravn