Monetary and Fiscal Policy: Some New Monetarist Arithmetic

Following Sargent and Wallace’s ‘Some Unpleasant Monetarist Arithmetic,’ we study different ways to implement monetary and fiscal policy.

Following Sargent and Wallace’s ‘Some Unpleasant Monetarist Arithmetic,’ we study different ways to implement monetary and fiscal policy. In one case, monetary policy pegs the path of the money supply, while fiscal policy adjusts endogenously to balance the budget. In another, fiscal policy pegs the deficit path, while money adjusts to balance the budget. We ask which is more prone to instability – i.e., more likely to have multiple equilibria, endogenous dynamics, or volatile responses to news? The answer depends on whether inflation (equivalently, the deficit) is positive or negative in the long run. This is consistent with cross-country data.