Monetary and Fiscal Cooperation

Abstract

The model of unemployment, inflation, and the structural deficit can be represented by a system of three equations:

$$ u=A-M-G $$

(1)

$$ \pi=B+M+G $$

(2)

$$ s=G-T $$

(3)

The policy makers are the central bank and the government. The targets of policy cooperation are zero inflation, zero unemployment, and a zero structural deficit. The instruments of policy cooperation are money supply and government purchases. There are three targets but only two instruments, so what is needed is a loss function:

$${\rm L} = \pi^2 + {\rm u}^2 + {\rm s}^2$$

(4)

L is the loss caused by inflation, unemployment, and the structural deficit. We assume equal weights in the loss function. The specific target of policy cooperation is to minimize the loss, given the inflation function, the unemployment function, and the structural deficit function.