Is monetary and fiscal policy conflict that dire?

Abstract

Theory predicts that inflation can become unstable when policymakers are in conflict about their post-recession recovery strategies, with the fiscal authority actively borrowing and spending to stimulate economic growth while the monetary authority raises interest rates to tame inflation. Such policy conflict can generate a debt-inflation spiral when agents are forward-looking. We show that the dire effects of policy conflict are less concerning when agents form backward-looking expectations. We then test this prediction in a learning-to-forecast experiment. Our results suggest that policy conflict does not necessarily lead to worse economic outcomes. This finding is driven by the fact that agents rely mostly on recent macroeconomic trends to formulate their expectations and do not meaningfully factor the government debt level or future regime shifts into their expectations.