Infrequent Fiscal Stabilization

We study discretionary non-cooperative monetary and fiscal policy stabilization in the New Keynesian model, where the fiscal authority uses distortionary taxes as policy instrument. We explicitly model different frequencies of fiscal and monetary policy operations. We find that standard models of monetary and fiscal policy interactions may substantially overestimate the social gain from the stabilization. Dynamic complementarities between monetary and fiscal policies are greatly amplified if the fiscal policymaker acts infrequently. We demonstrate the existence of expectations traps, so the economy may experience high volatility of macroeconomic variables. We also find that, in some situations, credible discretionary policy may not exist, and a commitment device is required in order to deliver a socially acceptable outcome.