Macroeconomic stabilization policy for a dynamic economy: variations on a model by Leitmann and Wan.

Abstract

In this paper, we modify and extend a model of macroeconomic stabilization policies for a dynamic economy by Leitmann and Wan. We combine a model of long-run output growth and a steady state of no growth with a model of short-run deviations from this growth path based on Keynesian and Monetarist macroeconomic hypotheses. We determine numerically the effects of demand and supply shocks and approximately optimal reactions of fiscal and monetary policies to these shocks for a policy maker in charge of both fiscal and monetary policy using an optimal control algorithm. We also formulate a dynamic game between government (fiscal policy) and central bank (monetary policy) with separate instruments and different preferences for the trade-off between unemployment and inflation and solve it numerically for the noncooperative feedback Nash equilibrium solution and a Pareto optimal solution. The results provide insights into the possibilities of active fiscal and monetary policies and of cooperation and possible conflicts between the institutions responsible for these policies.