Fiscal policy and the monetary transmission mechanism

Abstract

The economy's response to monetary policy depends on its fiscal backing. We present a novel decomposition of the equilibrium that links the wealth effect, i.e. the revaluation of households' financial and human wealth, to the fiscal response to monetary policy. When monetary policy has fiscal consequences, monetary variables affect the timing of aggregate output while fiscal variables shape its present value and the wealth effect. Consequently, a contractionary monetary policy reduces inflation only if followed by contractionary fiscal policy. The slope of the Phillips curve determines the importance of monetary-fiscal coordination for the effectiveness of monetary policy.