FISCAL AND MONETARY INTERACTIONS NOVEMBER 23, 2009 MONETARY POLICY AND FISCAL POLICY. Introduction

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1 FISCAL AND MONETARY INTERACTIONS NOVEMBER 23, 2009 Inroducion MONETARY POLICY AND FISCAL POLICY Chaper 7: udied fical policy in iolaion from moneary policy Illuraed ome core iue of fical policy (i.e., lifeime udge conrain of governmen, Ricardian Equivalence) Chaper 14: udied moneary policy in iolaion from fical policy Illuraed ome core iue of moneary policy (i.e., neuraliy deae, long-run moneari link eween money growh and inflaion) Moneary policy and fical policy don occur in vacuum iolaed from each oher Boh occur imulaneouly The conduc of fical policy can place rericion on wha moneary policy can do, and vice-vera Chaper 15: Ineracion eween fical and moneary policy Focu on dynamic unfolding of even Main idea: udge conrain/alance hee of one policy auhoriy affec he oher policy auhoriy Novemer 23,

2 Model Srucure MONETARY POLICY AND FISCAL POLICY Repreenaive conumer will e in he ackground, no he focu, of our analyi in Chaper 15 No explici uiliy maximizaion prolem, ec. Bu we know where opimal choice of c and M /P ec. come from Focu will ju e on governmen acion An infinie-period framework Two diinc ide of he governmen Fical auhoriy i.e., Congre/Treaury Conrol governmen pending g Collec axe T (will aume only lump-um axe hroughou) Iue (ell) new ond (for variou financing need) Moneary auhoriy (aka cenral ank) i.e., Fed Conrol money upply of economy y engaging in open-marke operaion Novemer 23, Model Srucure MONETARY POLICY AND FISCAL POLICY Repreenaive conumer will e in he ackground, no he focu, of our analyi in Chaper 15 No explici uiliy maximizaion prolem, ec. Bu we know where opimal choice of c and M /P ec. come from Focu will ju e on governmen acion An infinie-period framework The crucial linkage eween fical and moneary policy Two diinc ide of he governmen Fical auhoriy i.e., Congre/Treaury Conrol governmen pending g Collec axe T (will aume only lump-um axe hroughou) Iue (ell) new ond (for variou financing need) Receive profi from cenral ank (ecaue i legally charer C.B.) Moneary auhoriy (aka cenral ank) i.e., Fed Conrol money upply of economy y engaging in open-marke operaion Turn over any profi i earn o fical auhoriy Novemer 23,

3 Model Srucure FISCAL AUTHORITY Fical auhoriy acion decried y he period- udge conrain T T Pg + B = T + P B + RCB 1 Toal expendiure in period Toal income in period RCB : receip (profi) urned over from he cenral ank o he fical auhoriy in period B T : he TOTAL amoun of (one-period) ond (each wih FV = 1) Congre ell in period, each of which ha price P B T -1 : he TOTAL amoun of (one-period) ond (each wih FV = 1) ha Congre mu repay in period P Toal S wha Congre acually e OPEN MARKET FOR BONDS ond Novemer 23, Model Srucure FISCAL AUTHORITY Fical auhoriy acion decried y he period- udge conrain T T Pg + B = T + P B + RCB 1 Toal expendiure in period Toal income in period RCB : receip (profi) urned over from he cenral ank o he fical auhoriy in period B T : he TOTAL amoun of (one-period) ond (each wih FV = 1) Congre ell in period, each of which ha price P B T -1 : he TOTAL amoun of (one-period) ond (each wih FV = 1) ha Congre mu repay in period Fical auhoriy period +1 udge conrain P g + B = T + P B + RCB T T Toal expendiure in period +1 Toal income in period +1 And o on for +2, +3, ec. Novemer 23,

4 Model Srucure MONETARY AUTHORITY Moneary auhoriy acion decried y he period- udge conrain M M P B + RCB = B 1 + M M 1 Toal expendiure in period Toal income in period Fed doe no iue i own ond; i ranac uing fically-iued ond on he open marke RCB : profi urned over y he cenral ank o he fical auhoriy in period B M : he amoun of (one-period) ond (each wih FV = 1) Fed uy on open marke in period, each of which ha price P B M -1 : he payoff of (one-period) ond (each wih FV = 1) ha Fed receive in period M M -1 : he change in he money upply engineered y he cenral ank during he coure of period M and M -1 individually are ock variale, u M M -1 i a flow variale Moneary auhoriy period +1 udge conrain P B + RCB = B + M M M M And o on for period +2, +3, ec. Novemer 23, Model Srucure CONSOLIDATED GOVERNMENT BUDGET Can view he wo ide of he governmen a one conolidaed eniy M M T T P B + RCB = B 1 + M M 1 Pg + B 1 = T + P B + RCB Comine y eliminaing RCB Pg + B B = T + P ( B B ) + M M T M T M B T i he oal quaniy of fically-iued ond of which B M i purchaed y he cenral ank on he open marke B T B M i oal quaniy of fically-iued ond held y he privae ecor (i.e., conumer, muual fund, domeic inveor, foreign inveor, ec.) i.e., he quaniy availale on he open marke Define B = B T B M a ond held y he privae ecor Wha really maer for policy acion and ineracion Conolidaed flow governmen udge conrain 1 1 Novemer 23,

5 Model Srucure CONSOLIDATED GOVERNMENT BUDGET Conolidaed flow governmen udge conrain highligh he limi ha fical policy place on moneary policy and vice-vera 1 1 All analyi from he perpecive of he very eginning of period Fical policy in period i a paricular eing for all hree of i inrumen (g, T, B ) Fical policy ha hree inrumen (aka policy ool) Moneary policy in period i a paricular eing for all one of i inrumen (M ) Moneary policy ha one inrumen (aka policy ool) (Prolem Se 2: A policy i defined y unique eing for each availale inrumen) Novemer 23, Analyi ACTIVE VS. PASSIVE POLICY Definiion: A policy auhoriy i acive if every inrumen a i dipoal can e compleely freely choen, wihou any heed for he conolidaed governmen udge conrain Acive auhoriy doe no engage in policy in uch a way a o make ure he conolidaed governmen udge alance Definiion: A policy auhoriy i paive if no every inrumen a i dipoal can e compleely freely choen, wihou any heed for he conolidaed governmen udge conrain Paive auhoriy mu engage in policy in uch a way a o make ure he conolidaed governmen udge alance 1 1 A eginning of period, B -1 and M -1 are fixed (aume no defaul) Fical auhoriy e g, B,and T Moneary auhoriy e M Queion: How will coniency eween hem e guaraneed? Novemer 23,

6 Analyi ACTIVE VS. PASSIVE POLICY Definiion: A policy auhoriy i acive if every inrumen a i dipoal can e compleely freely choen, wihou any heed for he conolidaed governmen udge conrain Acive auhoriy doe no engage in policy in uch a way a o make ure he conolidaed governmen udge alance Definiion: A policy auhoriy i paive if no every inrumen a i dipoal can e compleely freely choen, wihou any heed for he conolidaed governmen udge conrain Paive auhoriy mu engage in policy in uch a way a o make ure he conolidaed governmen udge alance 1 1 i.e., how will equaliy of he conolidaed udge e achieved? A eginning of period, B -1 and M -1 are fixed (aume no defaul) Fical auhoriy e g, B,and T Moneary auhoriy e M Queion: How will coniency eween hem e guaraneed? Two poiiliie Novemer 23, Analyi ACTIVE FISCAL/PASSIVE MONETARY POLICY Suppoe fical auhoriy e all of i policy inrumen (all hree of hem) wihou heed for he conolidaed flow GBC Fical auhoriy i acive Moneary auhoriy mu reac y eing M o enure he conolidaed GBC hold Moneary auhoriy i paive Game-heoreic underone Fical auhoriy i he dominan policy-maker Fical auhoriy i he leader Moneary auhoriy i he lagging policy-maker Moneary auhoriy i he follower Policy preure (y fical auhoriy on moneary auhoriy) i implici and (largely ) hrough marke force U.S. Fed i independen of Congre Bu in developing counrie?... Novemer 23,

7 Analyi ACTIVE MONETARY/PASSIVE FISCAL POLICY Suppoe moneary auhoriy e all of i policy inrumen (all one of hem) wihou heed for he conolidaed flow GBC Moneary auhoriy i acive Fical auhoriy mu reac y eing a lea one of (g, T, B ) o enure he conolidaed GBC hold Fical auhoriy i paive ecaue i canno e all hree of i inrumen freely Game-heoreic underone Moneary auhoriy i he dominan policy-maker Moneary auhoriy i he leader Fical auhoriy i he lagging policy-maker Fical auhoriy i he follower Policy preure (y moneary auhoriy on fical auhoriy) i implici and (largely ) hrough marke force Novemer 23, Analyi ACTIVE VS. PASSIVE POLICY Which regime decrie he U.S.? Maer of a lo of deae Maye here regime wiching i.e., each auhoriy ake urn eing he follower and he leader Through he rie and fall of poliical power? Through he acendancy of rong cenral anker? Game heory a compelling way o udy moneary-fical ineracion (more advanced coure) Core iue: here are limi or rericion ha each policy-eing auhoriy place on he acion of he oher Analyi o far: he period- choice of one policy auhoriy reric he choice of he oher policy auhoriy in period NEXT A more nuanced view: he period- choice of one policy auhoriy may reric he choice of he oher policy auhoriy in period and/or period +1 and/or period +2 and/or period +3, Novemer 23,

8 FISCAL AND MONETARY INTERACTIONS: AN INTERTEMPORAL VIEW NOVEMBER 23, 2009 Inroducion ACTIVE VS. PASSIVE POLICY Core iue: here are limi or rericion ha each policy-eing auhoriy place on he acion of he oher Analyi o far: he period- choice of one policy auhoriy reric he choice of he oher policy auhoriy in period Period- conolidaed GBC 1 1 A more nuanced view: he period- choice of one policy auhoriy may reric he choice of he oher policy auhoriy in period and/or period +1 and/or period +2 and/or period +3, Emphaize ha he limi may no e realized immediaely, u can occur laer (in he economy /governmen lifeime) Require deriving/analyzing he lifeime (aka ineremporal) conolidaed governmen udge conrain Novemer 23,

9 Lifeime Conolidaed GBC SEIGNORAGE REVENUE Period- conolidaed GBC 1 1 B T P B M g + = + + P P P Divide y P o pu in real erm 1 1 M P r Definiion: eignorage revenue i he real quaniy of reource he governmen raie for ielf hrough he ac of money creaion Areviae r Prining money i a ource of income for he governmen! Unimporan in he U.S. (le han 1% of governmen revenue) and oher developed counrie Bu can e imporan in developing counrie (ecaue of poorlydeveloped ax collecion yem and corrupion) Play an imporan role in how fical-moneary ineracion affec exchange rae yem (Chaper 16, which we will no udy) Novemer 23, Lifeime Conolidaed GBC DERIVING THE LIFETIME CONSOLIDATED GBC Period- conolidaed GBC 1 1 B 1 T P B g + = + + r P P P Divide y P o pu in real erm Novemer 23,

10 Lifeime Conolidaed GBC DERIVING THE LIFETIME CONSOLIDATED GBC Period- conolidaed GBC 1 1 REAL value of governmen de ha mu e repaid a ar of period B 1 T P B g + = + + r P P P B = r + g + P Divide y P o pu in real erm Define = B /P, = T /P, and rearrange erm ( ) 1 P Period- conolidaed GBC Revenue generaed y moneary auhoriy acion B P + 1 Revenue generaed y fical auhoriy acion ( ) = r + g + P Comine Period-+1 conolidaed GBC (ame hing, ju updae ucrip) Complee mahemaical derivaion in Chaper 15 Ue Fiher equaion Suiue in +2 and +3 and +4, ec. udge conrain Ue Fiher equaion Comine Novemer 23, LIFETIME CONSOLIDATED GBC B g r (1 ) (1 ) = + P = 0 Π = 0 + r+ = 0 Π = 0 + r+ Lifeime Conolidaed GBC Lifeime conolidaed GBC REAL value of governmen de ha mu e repaid a ar of period Preen-dicouned value of all fical urplue aring in period Preen-dicouned value of all eignorage revenue aring in period The period- real value of governmen de ha mu e repaid can e repaid y eiher period- and/or laer fical urplue ( g i fical urplu recall erminology from Chaper 7) or period- and/or laer eignorage revenue or oh Conrolled y fical auhoriy Conrolled y cenral ank Boh fical urplue and eignorage revenue are ued in he conolidaed governmen udge o repay governmen de Queion: Which auhoriy i mo reponile for repaying de? Queion: When i hi auhoriy reponile for repaying i? Novemer 23,

11 Analyi RICARDIAN VS. NON-RICARDIAN POLICY When hinking aou dynamic (i.e., over many period) ineracion eween fical and moneary policy, uually he mo relevan cae i when fical auhoriy i acive (i.e., he leader ) Definiion: A Ricardian fical policy i in place if he fical auhoriy e i planned equence of ax and pending policy o enure ha he lifeime conolidaed GBC i aified Definiion: A non-ricardian fical policy i in place if he fical auhoriy e i planned equence of ax and pending policy wihou regard for wheher he lifeime conolidaed GBC i aified Wha maer i The fical auhoriy enire plan for, +1, +2, +3, +4,. The fical auhoriy enire plan for g, g +1, g +2, g +3, g +4,. Wheher and when he moneary auhoriy reac o wha he fical auhoriy chooe Novemer 23, Analyi: Cae 1 RICARDIAN CHANGES IN FISCAL POLICY B g r (1 ) (1 ) = + P = 0 Π = 0 + r+ = 0 Π = 0 + r+ Lifeime conolidaed GBC REAL value of governmen de ha mu e repaid a ar of period Preen-dicouned value of all fical urplue aring in period Preen-dicouned value of all eignorage revenue aring in period Sar of analyi: Fical auhoriy ha in place enire planned equence for and g Moneary auhoriy ha planned equence for r (i.e., money creaion) Fical auhoriy hen change he precie iming of collecion u doe o in a Ricardian way i.e., make ure i change collecion o a o aify he conolidaed GBC Queion: Wha i he impac on moneary policy (i.e., on r collecion)? NONE, ecaue fical policy i eing conduced in Ricardian way (The ai for Ricardian Equivalence from Chaper 7 ) Novemer 23,

12 Analyi: Cae 2 FISCAL THEORY OF INFLATION (FTI) B g r (1 ) (1 ) = + P = 0 Π = 0 + r+ = 0 Π = 0 + r+ Lifeime conolidaed GBC REAL value of governmen de ha mu e repaid a ar of period Preen-dicouned value of all fical urplue aring in period Preen-dicouned value of all eignorage revenue aring in period Sar of analyi: Fical auhoriy ha in place enire planned equence for and g Moneary auhoriy ha planned equence for r (i.e., money creaion) Fical auhoriy hen change he precie iming of collecion u doe o in a non-ricardian way Queion: Wha i he impac on moneary policy (i.e., on r collecion)? If moneary auhoriy aler i plan for r (i.e., money creaion), i ha reaced ( paive ) o enure lifeime conolidaed GBC hold Money-creaion lead o inflaion (moneari link of Chaper 14) Terminology Fical Theory of Inflaion Novemer 23, FISCAL THEORY OF THE PRICE LEVEL (FTPL) B g r (1 ) (1 ) = + P = 0 Π = 0 + r+ = 0 Π = 0 + r+ Analyi: Cae 3 Lifeime conolidaed GBC REAL value of governmen de ha mu e repaid a ar of period Preen-dicouned value of all fical urplue aring in period Preen-dicouned value of all eignorage revenue aring in period Sar of analyi: Fical auhoriy ha in place enire planned equence for and g Moneary auhoriy ha planned equence for r (i.e., money creaion) Fical auhoriy hen change he precie iming of collecion u doe o in a non-ricardian way Queion: Wha i he impac on moneary policy (i.e., on r collecion)? If moneary auhoriy doe no aler i r plan he enire adjumen mu come via a change in he period- price level A one-ime change in price, no a uained increae in price Novemer 23,

13 Moneary-Fical Ineracion MONETARY-FISCAL INTERACTIONS Doe Congre ac in a way o enure lifeime udge alance? Someime eem ye omeime eem no If no, hen FTI and FTPL are he wo relevan way ha lifeime governmen udge alance can e rough aou FTI: Any non-ricardian change in fical policy announced in period will lead o inflaion in period and/or in fuure period FTPL: Any non-ricardian change in fical policy announced in period will lead o a one-ime (i.e., in period ) change in price, u no furher inflaion in fuure period FTI and FTPL differ in heir predicion of when fical preure have heir conequence on economy-wide price Immediaely (i.e., in he hor run): FTPL In he fuure (i.e., in he medium or long run): FTI Novemer 23,