In this paper, I focus on the stabilization properties of alternative simplified approaches to the conduct of monetary policy and fiscal policy. The paper is motivated by questions of topical interest in New Zealand, for example what the costs might be in terms of lost credibility if the Reserve Bank of New Zealand were to have multiple goals rather than the exclusive goal of price stability, and whether output smoothing might significantly reduce the costs of the economy adjusting to shocks without compromising the long-run goals of a low rate of inflation and sustainable, prudent long-run evolution in the government’s budget.
The paper uses an illustrative model of a small open economy with features like New Zealand’s, developed while the author was visiting New Zealand in the spring of 1966. The analysis evaluates several alternative combinations of monetary and fiscal rules by subjecting model variants in which these rules are embedded to representative shocks. Simulation results are presented primarily in graphical form. The paper shows that a highly open economy cannot be insulated from shocks regardless of how macroeconomic stabilization policy is conducted. But the paper also suggests that monetary-policy rules permitting output smoothing in addition to the primary goal of inflation avoidance can foster marginally improved economic performance.