Monetary and fiscal policy interactions in a post Keynesian open-economy model

ABSTRACT

Using a post Keynesian model, this study aims to analyze the stabilizing role of fiscal and monetary policies in an open economy with a managed exchange rate regime. The real exchange rate is modeled as an endogenous variable and inflation explained using the conflicting claims approach. The dynamic properties of macroeconomic equilibrium are evaluated in different regimes of fiscal and monetary policies. The main result of this study suggests that the preferred policy regime is the one in which economic authorities are complementary and fiscal policy plays an explicitly active role. In this regime, the fiscal policy must commit to the target for the rate of capacity utilization and the monetary authority must commit to the inflation target.

KEYWORDS:

• Fiscal policy
• monetary policy
• open economy
• post Keynesian economy

JEL CLASSIFICATIONS:

• E52
• E62
• E12

Notes

¹$$\rho =e+\mathrm{l}\mathrm{o}\mathrm{g}\left(P^{\ast }\right)-\mathrm{l}\mathrm{o}\mathrm{g}\left(P\right)$$ where e is the nominal exchange rate in logs, P* is the external price level, and P is the domestic price level.

²Considering the purpose of this study, the marginal propensity to consume was chosen to be described in an aggregate way. However, it is perfectly plausible to imagine different marginal propensities to consume among workers and capitalists, in a way that c_w(1 − π) + c_kπ = c, π is the profit share, c_w is the marginal propensity to consume of workers, and c_k is the marginal propensities to consume of capitalists.

³In the “pseudo-Taylor rule” used by Setterfield (2007), however, the fiscal authority observes both the economic activity level and the gap between the observed inflation and the target inflation. Nonetheless, one observes that, when stabilizing the economic activity level, the fiscal authority is also (indirectly) contributing to stabilizing inflation.

⁴The adoption of a fiscal policy rule contributes to reducing the lags of fiscal policy. For further detail, see Taylor (2000) and Arestis and Sawyer (2003).