Fiscal/Monetary Policy And The Price Level In An Open Economy

In this paper I investigate the relevance of the fiscal/monetary policy regime for dynamics of the price level in an open economy. I use the framework of fiscal theory of the price level, which offers a theoretical framework within which the price level is not determined solely by the actions of monetary policy. Indeed, a number of authors1 have shown that the combination of monetary and fiscal policy parameters (which determine the total government liabilities outstanding) is reflected in the price level in the economy.This paper extends the discussion of the relevance of fiscal/monetary regime for price level in an open economy setting and asks what is the relevance of the policy mix for determination of the price level. In particular, I am interested in the role that fiscal policy play. I also ask whether the international transmission of the shocks depends on the fiscal/monetary regime.In an open economy foreign bonds held at home enter the intertemporal budget constraint and therefore may affect the determination of prices. There are two possible sources of fluctuations in the foreign component of the home portfolio: international trade and the changes of exchange rate. The responsiveness of the fiscal authority to the changes of the outstanding debt determines the nature and magnitude of the effects of foreign shocks on the level of economic activity at home and on inflation in particular.To show this I use a simple model that generalizes the framework of Obstfeld and Rogoff (1995) to incorporate the possibility of the non Ricardian fiscal policy regime. The extension requires introduction of government nominal bonds. I model the stickiness of the prices following Calvo (1983)2 and explicitly specify the monetary and fiscal policy reaction function. Monetary authority uses a simple Taylor rule to set nominal interest rates in response to deviations of inflation and output from their steady state values3. The fiscal authority responds to the outstanding debt by raising taxes. I simulate the linearized form of the model to investigate the dynamic responses to monetary and fiscal policy shocks at home and abroad4. In this way I clearly illustrate the importance of the fiscal regime for the price dynamics in an open economy.