Abstract

There is a common view that if monetary and fiscal policy are to be used together for macroeconomic stabilization, they should pull in the same direction. We challenge this view by analyzing the optimal policy mix in a small open economy. We show that when the economy is hit by inflation shocks or exchange rate shocks, monetary and fiscal policy should pull in opposite directions. This policy mix makes more effective use of the exchange rate channel of monetary policy, allowing inflation to be reduced after a shock with lower costs in terms of unemployment. Only in the case of demand shocks, or if there are significant costs associated with the active use of the interest rate, should monetary and fiscal policy pull in the same direction. We then consider automatic stabilizers. As we show, for demand shocks, automatic stabilizers imply that monetary and fiscal policy pull in the same direction. For inflation and exchange rate shocks, on the other hand, automatic stabilizers imply that the two policy instruments pull in opposite directions. These policy interactions are all consistent with our results on the optimal policy mix. Strong automatic stabilizers could therefore serve as a substitute for optimal discretionary fiscal policy in open economies.