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Interest-rate & exchange-rate dynamics is studied in a game between the monetary & fiscal policymakers where the monetary policymaker targets inflation. In the Nash game, a conflict over the appropriate size of the output gap leads to excessive interest-rate & exchange-rate volatility. For this reason, there are benefits in restricting fiscal policymaking. If the fiscal policymaker, however, is considered to have a first-mover advantage, the fiscal policymaker will internalise its effect on monetary policy, & the conflict is resolved & interest-rate & exchange-rate volatility is reduced. 2 Appendixes, 24 References. [Copyright 2003 Elsevier B.V.]

This paper studies the strategic interaction between the fiscal and monetary authorities when the monetary policymaker pursues an underlying inflation target. Given that monetary policy is transparent and the fiscal policymaker can commit to a particular policy stance, the Stackelberg equilibrium can be implemented. If the conditions for Stackelberg leadership is not present, policies may end up in a Nash equilibrium, resulting in excessive interest and exchange rate volatility. Legislative restrictions on fiscal policy may then be stabilising, whereas they may be counterproductive in the Stackelberg case. ; publishedVersion

This paper studies the strategic interaction between the fiscal and monetary authorities when the monetary policymaker pursues an underlying inflation target. Given that monetary policy is transparent and the fiscal policymaker can commit to a particular policy stance, the Stackelberg equilibrium can be implemented. If the conditions for Stackelberg leadership is not present, policies may end up in a Nash equilibrium, resulting in excessive interest and exchange rate volatility. Legislative restrictions on fiscal policy may then be stabilising, whereas they may be counterproductive in the Stackelberg case.

According to recent literature on monetary policy, there are two different interpretations of inflation targeting; (1) an instrument rule that responds to a measure of inflation (forecast) deviations from target and (2) a discretionary optimizing strategy towards minimizing the inflation deviations from its target. This paper compares these strategies with some simple rules for monetary policy. In particular, attention is given to the strategies' impact on the traded and non-traded sectors of the economy. Our conclusions suggest that there are considerable advantages in committing to a specific interest rate rule instead of letting the central bank discretionarily decide on the inflation targeting policy. The paper also provides evidence that the Taylor rule may work reasonably well in an open economy setting and gives only partial support for the Ball (1998) critique. It also discusses the structural conditions for successful targeting of inflation.

The paper considers alternative monetary policy regimes within a calibrated macroeconomic model with a traded and a non-traded sector. Two classes of regimes are considered; inflation targeting and exchange rate targeting. When the target variable is completely stabilized, both rules have poor stabilizing properties for all real variables - nominal exchange rate targeting is even dynamically unstable. When the monetary authority places some weight on output stabilization in addition to the primary target variable, inflation targeting outperforms exchange rate targeting in terms of output stability in both the traded and the non-traded sectors.

We estimate the interdependence between US monetary policy and the S&P 500 using structural VAR methodology. A solution is proposed to the simultaneity problem of identifying monetary and stock price shocks by using a combination of short-run and long-run restrictions that maintains the qualitative properties of a monetary policy shock found in the established literature (CEE 1999). We find great interdependence between interest rate setting and stock prices. Stock prices immediately fall by 1.5 percent due to a monetary policy shock that raises the federal funds rate by ten basis points. A stock price shock increasing stock prices by one percent leads to an increase in the interest rate of five basis points. Stock price shocks are orthogonal to the information set in the VAR model and can be interpreted as non-fundamental shocks. We attribute a major part of the surge in stock prices at the end of the 1990s to these non-fundamental shocks.