Inflation Targeting Monetary and Fiscal Policies in a Two-Country Stock-Flow Consistent Model

Abstract

This paper develops a simple two-country stock–flow-consistent model based on that of Godley and Lavoie. In order to motivate the use of stabilisation policies, persistent inflationary pressure and endogenous economic cycles are introduced into the model. Three scenarios are then simulated: a step decrease in real exports from country B, increased wage pressure in country B and an income tax cut in country A. In all cases, monetary and fiscal policies in isolation enjoy little success, but a combined monetary and fiscal approach to stabilisation proves highly effective. Moreover, the model suggests that the pursuit of autonomous inflation targeting in each country introduces excessive exchange rate volatility relative to an alternative rule in which one central bank takes a leading role in interest rate setting.