Strategic Interactions in U.S. Monetary and Fiscal Policies

We estimate a model in which fiscal and monetary policy behavior arise from the optimizing behavior of distinct policy authorities, with potentially different welfare functions. Optimal time-consistent policy behavior fits U.S. time series at least as well as rules-based behavior. American policies often do not conform to the conventional mix of conservative monetary policy and debt-stabilizing fiscal policy. Even after the Volcker disinflation, policies did not achieve that conventional mix, as fiscal policy did not act to stabilize debt until the mid 1990s. A credible conservative central bank that follows a time-consistent fiscal policy leader would come close to mimicking the cooperative Ramsey policy. Had that strategic policy mix been in place, American might have avoided the Great Inflation. Enhancing cooperation between policy makers without an ability to commit may be detrimental to welfare.