Interactions of fiscal and monetary policies under waves of optimism and pessimism

In this article we study fiscal and monetary policies interaction under the assumption that agents have limited cognitive capabilities. To this aim, we employ a behavioral New Keynesian model in which agents' beliefs generate endogenous waves of optimism and pessimism. The role of such waves is studied under three alternative policy setups: fiscal dominance, monetary dominance and no dominance. Output, inflation, government spend-ing and public debt result to be strongly linked to the agents' beliefs irrespectively of the policy regime. However, under fiscal dominance the system is characterized by more per-sistent waves of optimism and pessimism. The consequent higher volatility of the system under fiscal dominance also undermines the central bank's credibility. We show that in order to minimize these negative effects of fiscal dominance, under such a regime govern-ments should focus on public debt stabilization and leave the stabilization of output and inflation to the monetary authority.& COPY; 2023 The Author(s). Published by Elsevier B.V. This is an open access article under the CC BY license ( http://creativecommons.org/licenses/by/4.0/ )