The Credibility of Monetary Policy and Procyclical Fiscal Policy

Abstract

If indiscipline fiscal policy could affect the monetary policy’s objective and effectiveness, is it necessarily mean that the status quo of monetary policy credibility would also be impacted? This paper addresses the issue by constructing a simple theoretical model and conducting empirical investigations using a dataset from 25 selected Inflation Targeting Framework countries throughout 2003-2017. By employing the Generalized Method of Moments, we find that the monetary policy will remain the status quo credible as the central bank would optimally respond to the disturbances originated from procyclical fiscal policy. However, such a response potentially crowds out domestic investment and slows down the economy, and induces financial instability. This implies that bearing the eye only on the status quo credibility of monetary policy is not sufficient, and the consideration over the fiscal policy behavior becomes crucial.