Asset Stocks and the Use of Monetary and Fiscal Policies to Reduce Inflation

This paper analyzes the dynamic behaviour of a country's economy under different policy regimes, by examining the cyclical effects that occur when certain intermediate macroeconomic targets are adopted. To highlight the differences in the adjustment paths that result, the study deliberately limits policy choice: either money supply or nominal income as targets, and either real interest rates or tax-financed government spending as instruments. Successively more complicated models are considered as the capital stock, government debt outstanding; and net claims on foreigners are introduced. For these models, the main conclusion is that targetting money supply is likely to bring about a more cyclical path for an economy than targetting nominal income. In addition, using the real interest rate as instrument may produce instability, that is, explosive adjustment, when asset stocks are included in the model—and indeed instability will be present when increases in spending are financed by government debt issue. The government spending instrument, when tax financed, is less likely to result in instability. However, whether a country is a net creditor or a net debtor is shown to be important for open economy models: if the country is a large net debtor, any of the policy choices may imply instability.