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Monetary and Fiscal Policy Interactions Under a Stability Pact

The paper analyses in a simple setting a game between an inflation-conservative central bank and a fiscal authority subject to an upper limit on the budget deficit. It is shown that complementarity or substitutability between the policies and the preference of each authority for the other authority's behaviour crucially depends on the type of shock hitting the economy. If the government attempts to stimulate output beyond its natural level, a "deficit bias" emerges under non-cooperation; under cooperation, the equilibrium is characterised by both a "deficit bias" and an "inflation bias". However, if the government only pursues cyclical stabilisation these biases disappear and there are positive gains from coordinating the policy responses to shocks.