The Fiscal-Monetary Policy Mix and Exchange Rate Stability: A Dynamic Stochastic General Equilibrium Model With Chinese Characteristics

Abstract

We develop a small open economy model and compare alternative fiscal-monetary policy mixes using data for China. We show that the trade-offs faced by policy makers involve not only the stabilization of output, inflation, and real exchange rates, but also government debt stability. The source of shocks has important implications for the trade-offs. In the face of external shocks to interest rates or inflation, a passive fiscal and active monetary policy mix performs well in stabilizing government liabilities, inflation, and real exchange rates but generates higher output volatility. An active fiscal and active monetary policy mix is much more stabilizing in response to internal shocks to government expenditures or sector-specific productivity.