Fiscal and monetary policy interactions: a game theory approach

The interaction between fiscal and monetary policy is analyzed by means of a game theory approach. The coordination between these two policies is essential, since decisions taken by one institution may have disastrous effects on the other one, resulting in welfare loss for the society. We derived optimal monetary and fiscal policies in context of three coordination schemes: when each institution independently minimizes its welfare loss as a Nash equilibrium of a normal form game; when an institution moves first and the other follows, in a mechanism known as the Stackelberg solution; and, when institutions behave cooperatively, seeking common goals. In the Brazilian case, a numerical exercise shows that the smallest welfare loss is obtained under a Stackelberg solution which has the monetary policy as leader and the fiscal policy as follower. Under the optimal policy, there is evidence of a strong distaste for inflation by the Brazilian society.