FISCAL AND MONETARY INTERACTIONS JUNE 15, 2011 MONETARY POLICY AND FISCAL POLICY. Introduction

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1 FISCAL AND MONETARY INTERACTIONS JUNE 15, 2011 Introduction MONETARY POLICY AND FISCAL POLICY Chapter 7: tudied fical policy in iolation from monetary policy Illutrated ome core iue of fical policy (i.e., lifetime udget contraint of government, Ricardian Equivalence) Chapter 14: tudied monetary policy in iolation from fical policy Illutrated ome core iue of monetary policy (i.e., neutrality deate, long-run monetarit link etween money growth and inflation) Monetary policy and fical policy don t occur in vacuum iolated from each other Both occur imultaneouly The conduct of fical policy can place retriction on what monetary policy can do, and vice-vera Chapter 15: Interaction etween fical and monetary policy Focu on dynamic unfolding of event Main idea: udget contraint/alance heet of one policy authority affect the other policy authority June 15,

2 Model Structure MONETARY POLICY AND FISCAL POLICY Repreentative conumer will e in the ackground, not the focu, of analyi in Chapter 15 No explicit utility maximization prolem, etc. But we know where optimal choice of c t and M t /P t etc. come from Focu will jut e on government action An infinite-period framework Two ditinct ide of the government Fical authority i.e., Congre/Treaury Control government pending g t Collect taxe T t (will aume only lump-um taxe throughout) Iue (ell) new ond (for variou financing need) Monetary authority (aka central ank) i.e., Fed Control money upply of economy y engaging in open-market operation June 15, Model Structure MONETARY POLICY AND FISCAL POLICY Repreentative conumer will e in the ackground, not the focu, of analyi in Chapter 15 No explicit utility maximization prolem, etc. But we know where optimal choice of c t and M t /P t etc. come from Focu will jut e on government action An infinite-period framework Balance heet linkage etween fical and monetary policy Two ditinct ide of the government Fical authority i.e., Congre/Treaury Control government pending g t Collect taxe T t (will aume only lump-um taxe throughout) Iue (ell) new ond (for variou financing need) Receive profit from central ank (ecaue it legally charter C.B.) Monetary authority (aka central ank) i.e., Fed Control money upply of economy y engaging in open-market operation Turn over any profit it earn to fical authority June 15,

3 Model Structure FISCAL AUTHORITY Fical authority udget contraint in period t Pg B = T P B RCB T T t t t 1 t t t t Total outlay in period t Total inflow in period t B T t: the TOTAL amount of (one-period) ond (each with FV = 1) Congre ell in period t, each of which ha price P t B T t-1: the TOTAL amount of (one-period) ond (each with FV = 1) that Congre mut repay in period t RCB t : receipt (profit) turned over from the central ank to the fical authority in period t Fical authority udget contraint in period t1 P g B = T P B RCB T T t 1 t 1 t t 1 t 1 t 1 t 1 Total outlay in period t1 Total inflow in period t1 And o on for t2, t3, etc. June 15, Model Structure MONETARY AUTHORITY Monetary authority udget contraint in period t P B RCB = B M M M M t t t t 1 t t 1 Total outlay in period t Total inflow in period t Fed doe not iue it own ond; it tranact uing fically-iued ond on the open market B M t: the amount of (one-period) ond (each with FV = 1) Fed uy on open market in period t, each of which ha price P t B M t-1: the payoff of (one-period) ond (each with FV = 1) that Fed receive in period t RCB t : profit turned over y the central ank to the fical authority in period t June 15,

4 Model Structure MONETARY AUTHORITY Monetary authority udget contraint in period t P B RCB = B M M M M t t t t 1 t t 1 Total outlay in period t Total inflow in period t Fed doe not iue it own ond; it tranact uing fically-iued ond on the open market B M t: the amount of (one-period) ond (each with FV = 1) Fed uy on open market in period t, each of which ha price P t B M t-1: the payoff of (one-period) ond (each with FV = 1) that Fed receive in period t RCB t : profit turned over y the central ank to the fical authority in period t M t M t-1 : the change in the money upply engineered y the central ank during the coure of period t M t and M t-1 individually are tock variale, ut M t M t-1 i a flow variale Monetary authority udget contraint in period t1 P B RCB = B M M M M t 1 t 1 t 1 t t 1 t And o on for period t2, t3, etc. June 15, Model Structure CONSOLIDATED GOVERNMENT BUDGET Can view two ide of the government a one conolidated entity M M T T Pt Bt RCBt = Bt 1 M t M t 1 Ptgt Bt 1 = Tt Pt Bt RCBt Comine y eliminating RCB t Pg B B = T P ( B B ) M M T M T M t t t 1 t 1 t t t t t t 1 B T i the total quantity of fically-iued ond of which B M i purchaed y the central ank on the open market B T B M i total quantity of fically-iued ond held y the private ector (i.e., conumer, mutual fund, dometic invetor, foreign invetor, etc.) i.e., the quantity availale on the open market June 15,

5 Model Structure CONSOLIDATED GOVERNMENT BUDGET Can view two ide of the government a one conolidated entity M M T T Pt Bt RCBt = Bt 1 M t M t 1 Ptgt Bt 1 = Tt Pt Bt RCBt Comine y eliminating RCB t Pg B B = T P ( B B ) M M T M T M t t t 1 t 1 t t t t t t 1 B T i the total quantity of fically-iued ond of which B M i purchaed y the central ank on the open market B T B M i total quantity of fically-iued ond held y the private ector (i.e., conumer, mutual fund, dometic invetor, foreign invetor, etc.) i.e., the quantity availale on the open market Define B = B T B M a ond held y the private ector What really matter for policy action and interaction Conolidated flow government udget contraint (GBC) Pg B = T P B M M t t t 1 t t t t t 1 June 15, Short-Run Interaction CONSOLIDATED GOVERNMENT BUDGET Conolidated flow government udget contraint highlight the hort-run limit that fical policy place on monetary policy and vice-vera Pg B = T P B M M t t t 1 t t t t t 1 All analyi from the perpective of the very eginning of period t Fical policy in period t i a particular etting for all three of it intrument (g t, T t, B t ) Fical policy ha three intrument (aka policy tool) Monetary policy in period t i a particular etting for all one of it intrument (M t ) Monetary policy ha one intrument (aka policy tool) (Prolem Set 2: A policy i defined y unique etting for each availale intrument) June 15,

6 Short-Run Interaction ACTIVE VS. PASSIVE POLICY Definition: A policy authority i active if every intrument at it dipoal can e completely freely choen, without any concern for the conolidated government udget contraint Active authority doe not engage in policy in uch a way a to make ure the conolidated government udget alance Definition: A policy authority i paive if not every intrument at it dipoal can e completely freely choen, without any concern for the conolidated government udget contraint Paive authority mut engage in policy in uch a way a to make ure the conolidated government udget alance June 15, Short-Run Interaction ACTIVE VS. PASSIVE POLICY Definition: A policy authority i active if every intrument at it dipoal can e completely freely choen, without any concern for the conolidated government udget contraint Active authority doe not engage in policy in uch a way a to make ure the conolidated government udget alance Definition: A policy authority i paive if not every intrument at it dipoal can e completely freely choen, without any concern for the conolidated government udget contraint Paive authority mut engage in policy in uch a way a to make ure the conolidated government udget alance Pg B = T P B M M t t t 1 t t t t t 1 i.e., how will equality of the conolidated udget e achieved? At eginning of period t, B t-1 and M t-1 are fixed (aume no default) Fical authority et g t, B t,and T t Monetary authority et M t Quetion: How will conitency etween them e guaranteed? Two poiilitie June 15,

7 Short-Run Interaction ACTIVE FISCAL/PASSIVE MONETARY POLICY Suppoe fical authority et all of it policy intrument (all three of them) without heed for the conolidated flow GBC Fical authority i?... Monetary authority mut react y etting M t to enure the conolidated GBC hold Monetary authority i?... Game-theoretic undertone Fical authority i the dominant policy-maker Fical authority i the leader Monetary authority i the lagging policy-maker Monetary authority i the follower Policy preure (y fical authority on monetary authority) i implicit and (largely ) through market force U.S. Fed i independent of Congre But in developing countrie?... June 15, Short-Run Interaction ACTIVE MONETARY/PASSIVE FISCAL POLICY Suppoe monetary authority et all of it policy intrument (all one of them) without heed for the conolidated flow GBC Monetary authority i?... Fical authority mut react y etting at leat one of (g t, T t, B t ) to enure the conolidated GBC hold Fical authority i?... ecaue it cannot et all three of it intrument freely Game-theoretic undertone Monetary authority i the dominant policy-maker Monetary authority i the leader Fical authority i the lagging policy-maker Fical authority i the follower Policy preure (y monetary authority on fical authority) i implicit and (largely ) through market force June 15,

8 Short-Run Interaction ACTIVE VS. PASSIVE POLICY Which regime decrie the U.S.? Matter of a lot of deate Maye there regime witching i.e., each authority take turn eing the follower and the leader Through the rie and fall of political power? Through the acendancy of trong central anker? Game theory a compelling way to tudy monetary-fical interaction (more advanced coure) Core iue: there are limit or retriction that each policy-etting authority place on the action of the other Analyi o far: the period-t choice of one policy authority retrict the choice of the other policy authority in period t A more nuanced view: the period-t choice of one policy authority may retrict the choice of the other policy authority in period t and/or period t1 and/or period t2 and/or period t3, June 15, FISCAL AND MONETARY INTERACTIONS: PRESENT-VALUE ANALYSIS JUNE 15,

9 Introduction ACTIVE VS. PASSIVE POLICY Core iue: there are limit or retriction that each policy-etting authority place on the action of the other Analyi o far: the period-t choice of one policy authority retrict choice of other policy authority in period t (i.e., in hort run) Pg B = T P B M M Period-t conolidated GBC t t t 1 t t t t t 1 A more nuanced view: the period-t choice of one policy authority may retrict the choice of the other policy authority in period t and/or period t1 and/or period t2 and/or period t3, Emphaize that the limit may not e realized immediately, ut can occur later (in the economy /government lifetime) Require analyzing the preent dicounted value (PDV) verion of the conolidated GBC (aka lifetime conolidated GBC) June 15, Preent-Value Conolidated GBC DERIVING THE LIFETIME CONSOLIDATED GBC Pg B = T P B M M Period-t conolidated GBC t t t 1 t t t t t 1 Divide y P t to put in real term B T P B M M gt = P P P P t 1 t t t t t 1 t t t t June 15,

10 Preent-Value Conolidated GBC SEIGNORAGE REVENUE Pg B = T P B M M Period-t conolidated GBC t t t 1 t t t t t 1 B T P B M gt = P P P Divide y P t to put in real term t 1 t t t t t 1 t t t M P t r t Definition: eignorage revenue i the real quantity of reource the government raie for itelf through the act of money creation Areviate r t Printing money i a ource of income for the government! Generally unimportant in the U.S. (le than 1% of government revenue) and other developed countrie But can e important in developing countrie (ecaue of poorlydeveloped tax collection ytem and corruption) Play an important role in how fical-monetary interaction affect exchange rate ytem (Chapter 16, which we will not tudy) June 15, Preent-Value Conolidated GBC DERIVING THE LIFETIME CONSOLIDATED GBC Pg B = T P B M M Period-t conolidated GBC t t t 1 t t t t t 1 REAL value of government det that mut e repaid at tart of period t Bt 1 Tt Pt Bt gt = rt P P P t t t B = r t g P Divide y P t to put in real term Define t = B t/p t, t t = T t/p t, and rearrange term ( ) t 1 t t t t t Pt Revenue generated y monetary authority action Revenue generated y fical authority action Period-t conolidated GBC June 15,

11 Preent-Value Conolidated GBC DERIVING THE LIFETIME CONSOLIDATED GBC Pg B = T P B M M Period-t conolidated GBC t t t 1 t t t t t 1 REAL value of government det that mut e repaid at tart of period t Bt 1 Tt Pt Bt gt = rt P P P t t t B = r t g P Divide y P t to put in real term Define t = B t/p t, t t = T t/p t, and rearrange term ( ) t 1 t t t t t Pt Period-t conolidated GBC Revenue generated y monetary authority action Bt P t 1 Revenue generated y fical authority action ( ) = r t g P t 1 t 1 t 1 t 1 t 1 Comine Period-t1 conolidated GBC (ame thing, jut update ucript) Complete mathematical derivation in Chapter 15 Ue Fiher equation Sutitute in t2 and t3 and t4, etc. udget contraint Ue Fiher equation Comine June 15, LIFETIME CONSOLIDATED GBC B t g r (1 ) (1 ) t 1 t t t = Pt = 0 Π = 1 rt = 0 Π = 1 rt Preent-Value Conolidated GBC Preent-value conolidated GBC June 15,

12 Preent-Value Conolidated GBC LIFETIME CONSOLIDATED GBC REAL value of government det that mut e repaid at tart of period t B t g r (1 ) (1 ) t 1 t t t = Pt = 0 Π = 1 rt = 0 Π = 1 rt Preent-value Preent-dicounted value of all fical urplue tarting in period t Preent-dicounted value of all eignorage revenue tarting in period t conolidated GBC The period-t real value of maturing government det mut e repaid y either period-t and/or later fical urplue (t g i real fical urplu in any given year recall from Chapter 7) or year-t and/or later eignorage revenue or oth Or later implie rolling over maturing det Borrowing anew to repay det that i due Real value of maturing government det at tart of 2011 B tax g tax g tax g = ( tax g )... P 1 r (1 r )(1 r ) (1 r )(1 r )(1 r ) r2012 r2013 r2014 r r2012 (1 r2012)(1 r2013) (1 r2012)(1 r2013)(1 r2... ) June 15, PDV of fical urplue/deficit in 2011 and eyond PDV of eignorage revenue in 2011 and eyond LIFETIME CONSOLIDATED GBC REAL value of government det that mut e repaid at tart of period t B t g r (1 ) (1 ) t 1 t t t = Pt = 0 Π = 1 rt = 0 Π = 1 rt Preent-Value Conolidated GBC Preent-value Preent-dicounted value of all fical urplue tarting in period t Preent-dicounted value of all eignorage revenue tarting in period t conolidated GBC The period-t real value of maturing government det mut e repaid y either period-t and/or later fical urplue (t g i real fical urplu in any given year recall from Chapter 7) or year-t and/or later eignorage revenue or oth Or later implie rolling over maturing det Borrowing anew to repay det that i due Key idea: preent value conolidated GBC indicate that oth fical adjutment and money creation policie can e ued to pay government det But money creation typically park inflation Expanion of money upply value of each unit of money fall (i.e., price of good rie) June 15,

13 Long-Run Interaction RICARDIAN VS. NON-RICARDIAN POLICY In conidering dynamic (i.e., over many period) interaction etween fical and monetary policy, mot relevant cae i uually when fical authority i active (i.e., the leader ) Definition: A Ricardian fical policy i in place if the fical authority et it planned equence of tax and pending policy to enure that preent-value conolidated GBC i atified Definition: A non-ricardian fical policy i in place if the fical authority et it planned equence of tax and pending policy without regard for whether preent-value conolidated GBC i atified What matter i The fical authority entire plan for t t, t t1, t t2, t t3, t t4,. The fical authority entire plan for g t, g t1, g t2, g t3, g t4,. Whether and when the monetary authority react to what the fical authority chooe June 15, Long-Run Interaction: Cae 1 RICARDIAN CHANGES IN FISCAL POLICY B t g r (1 ) (1 ) t 1 t t t = Pt = 0 Π = 0 rt = 0 Π = 0 rt Preent-value conolidated GBC REAL value of government det that mut e repaid at tart of period t Preent-dicounted value of all fical urplue tarting in period t Preent-dicounted value of all eignorage revenue tarting in period t Start of analyi: Fical authority ha in place entire planned equence for t and g Monetary authority ha planned equence for r (i.e., money creation) Fical authority then change the precie timing of t collection ut doe o in a Ricardian way i.e., make ure it change t collection o a to atify the preentvalue conolidated GBC Quetion: What i the impact on monetary policy (i.e., on r collection)? June 15,

14 FISCAL THEORY OF INFLATION (FTI) Long-Run Interaction: Cae 2 B t g r (1 ) (1 ) t 1 t t t = Pt = 0 Π = 0 rt = 0 Π = 0 rt Preent-value conolidated GBC REAL value of government det that mut e repaid at tart of period t Preent-dicounted value of all fical urplue tarting in period t Preent-dicounted value of all eignorage revenue tarting in period t Start of analyi: Fical authority ha in place entire planned equence for t and g Monetary authority ha planned equence for r (i.e., money creation) Fical authority then change the precie timing of t collection ut doe o in a non-ricardian way Quetion: What i the impact on monetary policy (i.e., on r collection)? June 15, FISCAL THEORY OF INFLATION (FTI) Long-Run Interaction: Cae 2 B t g r (1 ) (1 ) t 1 t t t = Pt = 0 Π = 0 rt = 0 Π = 0 rt Preent-value conolidated GBC REAL value of government det that mut e repaid at tart of period t Preent-dicounted value of all fical urplue tarting in period t Preent-dicounted value of all eignorage revenue tarting in period t Start of analyi: Fical authority ha in place entire planned equence for t and g Monetary authority ha planned equence for r (i.e., money creation) Fical authority then change the precie timing of t collection ut doe o in a non-ricardian way Quetion: What i the impact on monetary policy (i.e., on r collection)? If monetary authority alter it plan for r (i.e., money creation), it ha reacted ( paive ) to enure preent-value conolidated GBC hold Money-creation lead to inflation (monetarit link of Chapter 14) Terminology Fical Theory of Inflation June 15,

15 Long-Run Interaction: Cae 3 FISCAL THEORY OF THE PRICE LEVEL (FTPL) B t g r (1 ) (1 ) t 1 t t t = Pt = 0 Π = 0 rt = 0 Π = 0 rt Preent-value conolidated GBC REAL value of government det that mut e repaid at tart of period t Preent-dicounted value of all fical urplue tarting in period t Preent-dicounted value of all eignorage revenue tarting in period t Start of analyi: Fical authority ha in place entire planned equence for t and g Monetary authority ha planned equence for r (i.e., money creation) Fical authority then change the precie timing of t collection ut doe o in a non-ricardian way Quetion: What i the impact on monetary policy (i.e., on r collection)? If monetary authority doe not alter it r plan the entire adjutment mut come via a change in the period-t price level A one-time change in price, not a utained increae in price June 15, Monetary-Fical Interaction MONETARY-FISCAL INTERACTIONS Doe Congre act in a way to enure long-run udget alance? Sometime eem ye ometime eem no If not, then inflationary finance (FTI or FTPL) an important concern When would effect of inflationary finance e felt in economy? Timing not at all clear June 15,

16 Monetary-Fical Interaction MONETARY-FISCAL INTERACTIONS Doe Congre act in a way to enure long-run udget alance? Sometime eem ye ometime eem no If not, then inflationary finance (FTI or FTPL) an important concern When would effect of inflationary finance e felt in economy? Timing not at all clear FTI: effect of inflationary finance felt a a long and utained (though not necearily very harp) rie in inflation In period t and/or in future period FTPL: effect of inflationary finance felt a a hort-lived ut very harp rie in inflation A one-time (i.e., in period t) change in price, ut no further inflation in future period Many hitorical epiode in developing countrie of FTPL Little empirical evidence for developed countrie (o far ) June 15,