The Fiscal-Monetary Policy Mix and Exchange Rate Stability: A Dynamic Stochastic General Equilibrium Model With Chinese Characteristics

Abstract

We develop a small open economy model and compare alternative fiscal-monetary policy mixes using data for China. We show that the trade-offs faced by policy makers involve not only the stabilization of output, inflation, and real exchange rates, but also government debt stability. The source of shocks has important implications for the trade-offs. In the face of external shocks to interest rates or inflation, a passive fiscal and active monetary policy mix performs well in stabilizing government liabilities, inflation, and real exchange rates but generates higher output volatility. An active fiscal and active monetary policy mix is much more stabilizing in response to internal shocks to government expenditures or sector-specific productivity.KEY WORDS: fiscal policy, fiscal-monetary policy mix, real exchange rates, government debts, two-sector small open economy model, ChinaSince the financial crisis in the late 1990s, how to design macroeconomic policies to stabilize exchange rates, especially for emerging market economies, has increasingly drawn attention from policy makers and academia. Using a dynamic stochastic general equilibrium (DSGE) model, Smets and Wouters (2002) analyze optimal monetary policy in an open economy with incomplete exchange rate pass-through. Devereux et al. (2006) study the effects of incomplete exchange rate pass-through and external borrowing constraints on the conduct of monetary policy for an emerging market economy. De Paoli (2009) analyzes optimal monetary policy using a small open economy model with a special focus on whether the exchange rate stability should be part of monetary policy strategy. Recently, Lombardo and Ravenna (2014) explore the effect of the trade composition on optimal monetary policy and optimal volatility of the exchange rate. Chang et al. (2014) identify the importance of the cost channel of monetary policy in a small open economy with financial frictions.However, most of these studies have been conducted in the context of highly stylized economic and policy environments. They typically examine optimal monetary policy in a nonmonetary economy, which introduces an inflation-stabilization bias because the demand for money creates a motive to stabilize nominal interest rates rather than inflation. More strikingly, these studies oversimplify the behaviors of the fiscal authority by only considering the lump-sum taxation and ignoring distortionary taxations and government debts. As indicated by Schmitt-Grohe and Uribe (2007), these studies implicitly assume that the government always follows the balanced budget rule and, thus, adopt Leeper's (1991) passive fiscal policy, which is inconsistent with fiscal policy practices in most emerging market economies. For example, Guo et al. (2011) identify an active fiscal policy in China before 1998. Moreover, one strand of the literature has shown that, given monetary policy, the determinacy properties of inflation or exchange rates depend on the nature of fiscal policy (for example, Daniel 2001;Leeper 1991). Hence, the fis...

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