Fiscal and Monetary Policy Interactions in a New Keynesian Model with Liquidity Constraints

Abstract

This paper derives a New Keynesian dynamic general equilibrium model with liquidity constrained consumers and sticky prices. The model allows a role for both government spending and taxation in the DGE model. The model is then estimated using Euro area data. We demonstrate that there seems to be a significant role for rule-of-thumb consumer behaviour. Our model is then used to analyse the interaction between fiscal and monetary policies. We examine the extent to which fiscal policy (automatic stabilisers) assist or hinder monetary policy when the latter takes a standard forward-looking inflation targeting form. We also examine the extent to which inertia in fiscal policy and the presence of rule-of-thumb consumers affects output and inflation variability in the presence of such a monetary policy rule.