Coordination without Explicit Cooperation: Monetary-Fiscal Interactions in an Era of Demographic Change

Early work on the theory of economic policy stressed the importance of accounting for the interactions between fiscal and monetary policy. Tinbergen, and Cooper, taught us that there would be costs in missed targets, instability, and protracted imbalances if this was not done. Yet most models we use today treat fiscal or monetary policies as if they operated alone. This paper reviews the advantages of recognising those interactions. We consider three possibilities: fiscal leadership (in the sense of a longer term precommitment), monetary leadership, and simultaneous decision making, each underpinned by independence at the central bank. Temporal separation is important because it creates an opportunity for punishment by the follower (a result from asynchronous games). Making fiscal policy lead therefore provides fiscal precommitment, and the best results for output, inflation and fiscal balances. In particular it ensures fiscal sustainability, without the need for arbitrary and easily evaded numerical rules. We show these results are proof against override by rational governments; and robust to market reforms that flatten the Phillips curve, or globalisation and the changes in savings caused by the ageing problem.