Monetary and Fiscal Policy Interaction: The Current Consensus Assignment in the Light of Recent Developments

Abstract

In the last few years papers have begun to analyse optimal monetary and fiscal policy in models incorporating nominal rigidities where social welfare is derived from the utility of agents. This article examines whether this analysis provides support for the consensus assignment, where monetary policy controls demand and inflation and fiscal policy controls government debt. We argue that the basic structure of New Keynesian models implies that monetary policy dominates fiscal policy as a means of controlling inflation. No similar dominance appears to operate for fiscal policy and debt, if debt has to return to its initial level after shocks.