Interaction between Monetary and
Fiscal Policy and the Policy Mix
Theoretical Consideration and Japanese Experience*

Yasushi Iwamoto**
University of Tokyo

August 2005

Abstract
Interactions between monetary and fiscal policy depend on thespecification of policy variables that fiscal policy uses. However, a generalrule is that when monetary policy is capable of dealing with sticky priceadjustment, a primary concern of fiscal authority should be to remedy the
resource allocation. My regression study using cross-country data showsthat in a majority of OECD countries fiscal policy relies on the automaticstabilizer. Japan is a unique case in that it relies heavily on discretionary
fiscal policy. However, Japanese policymakers have recently changed theirthinking regarding fiscal policy.
JEL classification numbers: E63, E62, E52
Keywords: monetary and fiscal policy; policy mix; automatic stabilizer; inflation
targeting; tax smoothing*An earlier version of this paper was presented at the Bank of Korea International
Conference on the Effectiveness of Stabilization Policies, May 27, Seoul, Korea. I
would like to thank Micheal Artis and Kookshin Ahn for helpful comment. Part of myresearch is financially supported by Grants-in-Aid for Scientific Research 12124206
and 17530141 of the Ministry of Education.
**
Professor, Department of Economics, University of Tokyo, 7-3-1, Hongo,
Bunkyo-ku, Tokyo 113-0033, JAPAN.

1. Introduction

In the discussion of policy mix in the intermediate macroeconomics textbook,monetary policy and fiscal policy play an equal role in stabilizing economic fluctuations.
However, recent theory and practice presumes the division of labor regarding policies.
Fiscal policy is in charge of resource allocation, while monetary policy addresses
economic stabilization. The purpose of this paper is to discuss how and when theory
justifies this kind of separation, as well as to empirically examine how developed
countries have accepted this idea.
This paper will first give a theoretical review as means of introducing our
discussion of the separation of monetary and fiscal policy. Recently the analysis ofmonetary policy has dramatically advanced from the new Keynesian framework which
established a solid micro foundation of behavioral equations. A consideration of fiscal
policy under this framework has been newly developed by recent researchers such as
Benigno and Woodford (2003), Eggertsson and Woodford (2004), Schmitt-Grohe andUribe (2004) and Siu (2004). Under optimal policy management by a consolidated
government, monetary authority and fiscal authority seek to maximize a singular
objective function while under the same restrictions. Policy variables are included in the
consolidated government’s budget equation. In general, monetary policy and fiscal
policy closely interact; monetary policy cannot ignore fiscal concerns, while fiscal
policy should be concerned with output fluctuations. However, the above-mentioned
literature also characterized specific cases where the interaction between monetary andfiscal policy was inherently weak. In these situations, ignoring the interplay between
monetary and fiscal policy is accepted as good practice.
Taylor (2000) empirically examined the practice of fiscal policy in the UnitedStates. He focused on the relationship between the structural balance of government andthe output gap. He found that the structural balance did not respond to the output gap.
This implies that fiscal authority abandons discretionary policy and that fiscal policy
sticks to an automatic stabilizer. On the other hand, Gali and Perotti (2003) examined
how the Maastricht Treaty and the Stability and Growth Pact affected fiscal policy in
EU countries, and found that fiscal policy had become more countercyclical in the
post-Maastricht period (1992-2000).

-1-Section 2 will be a discussion of the interaction of monetary and fiscal policy
under the new Keynesian framework. In Section 3, the paper will take a look at the
recent practice of other OECD countries as well as examining the specific case of Japan.
My regression study using cross-country data indicates that fiscal policy works as an
automatic stabilizer in many OECD countries. Japan belongs to the opposite case; thestructural balance responds strongly to the output gap. In Section 4, the paper willfurther analyze the Japanese situation as well as identify key issues facing Japanese
fiscal policy.

-2-

2. Interaction Between Monetary and Fiscal Policy

2.1 Market Failures in the new Keynesian framework
This section gives a brief overview of the theoretical framework of monetary andfiscal policy from the viewpoint of new Keynesian economics. A principal focus of the
new Keynesian framework is to give a solid micro foundation of price adjustments.
Since the model needs to formulate the firm’s price setting behavior, they must havesome market power. Therefore, the model contains market failure caused by imperfectcompetition. Market power and sticky price adjustment force the economy to diverge
from the point of efficient resource allocation. The business cycle caused by the sticky
price adjustment is a market failure. Therefore, stabilization policy is a tool utilized by
the government to intervene and remedy market failure.
It is useful to decompose the fluctuation of output; market failure caused byimperfect competition and market failure caused by the sticky price adjustment. Let us
denote the actual output as Yt , the output under flexible price adjustment (natural
output) as Yt n , and the output under efficient resource allocation (efficient output) as

Yt* . Since the main concern of monetary policy is the cyclical fluctuations caused by the
sticky price, monetary theory usually focuses on the output gap xt ≡ log(Yt Yt n ). On

the other hand, since the evaluation of economic welfare is defined based on its
deviation from efficient resource allocation, another important variable to consider isthe difference between the actual output and the efficient output y t ≡ log(Yt Yt* ) .
Current research on monetary policy usually describes the movement of inflationand the output gap using the Expectation IS curve and the new Keynesian Phillips
curve.1 Following Benigno and Woodford (2003) and Eggertsson and Woodford (2004),
this paper presents a model that incorporates fiscal policy into the new Keynesianframework. The expectation IS curve is
xt = Et xt +1 − σ (log(1 + it ) − Etπ t +1 − rtn ) ,1(1)

For a derivation of the following equations, see Woodford (2003) and Benigno
and Woodford (2003).
-3-

where σ is the elasticity of intertemporal substitution, i is the nominal interest rate,

π t ≡ log(Pt Pt −1 ) is the inflation rate, and P is the price level. The natural interest rater n is the interest rate where the inflation rate is zero and the economy is at the naturallevel of output.
The new Keynesian Phillips curve is described as

π t = κ [ y t + ψτˆt + ut ] + βEtπ t +1 ,(2)which is derived from Calvo’s (1983) specification of firm’s price adjustment. In (2), κ
is a parameter, and τˆ is the tax rate that affects the supply side of the economy, and u
is a set of exogenous shock (other than the tax rate) to the efficient output and inflation,and β is the discount factor of consumers. The above equation implies that the
government can offset the shock by changing the tax rate. To highlight this fact, werearrange the equation (2) to

π t = κ [y t + ψ (τˆt − τˆt* )] + βEtπ t +1

(3)

where τˆ * stands for the tax rate that exactly offsets the movement of u. If the fiscal

authority sets τˆ as τˆ * , the difference between the efficient output and natural output
remains constant. Even when the true objective of the consolidated government is tominimize the deviation of output from its efficient level, the monetary authority isallowed to be concerned with the deviation of output from its natural level.
We consolidate the budget equations of the fiscal authority and the central bankinto one. The budget equations of the consolidated government are shown as
Bt = (1 + it −1 )Bt −1 − Pt st(4)st ≡ τ tYt − Gt − ζ t ,(5)where B stands for the nominal public debt, s the primary balance, τ the tax rate, and G
government expenditure, ζ exogenous transfer expenditure. The above equations can be-4-arranged as an equation for the real value of public debt ( b ≡ B P ):P
bt = (1 + it −1 ) t −1 bt −1 − (τ tYt − Gt − ζ t ) .
Pt(6)

2.2 Settings of policy variables in the budget of the consolidated government
Fiscal authority is responsible for controlling four variables in Equation (6). The
characteristics of these variables warrant further discussion. G and ζ are spending items.
They are separated because the latter does not cause the distortion of resource allocation,
while the former influences the natural output and the natural interest rate. Government
expenditures are usually considered as exogenous shocks, because each governmental
spending item has its own purpose which is separated from the scope of stabilization
policy. However, aspects of these items may be used as stabilization policy. An
alternative specification is to set ζ as a policy variable. Government debt is usuallyspecified as a safe nominal debt. Alternative specification is that the government
conducts a sophisticated debt management policy with the presence of state-contingent
government debts. Benigno and Woodford (2003) and Eggertsson and Woodford (2004)
use the tax rate as an instrument of stabilization policy. In contrast to monetary policy, it
is impractical to frequently adjust tax rates in response to economic conditions.
Taxation under a stabilization policy has been addressed in the context of tax
smoothing behavior, which was discussed by Barro (1979). When the consumers havethe infinite time horizon, and distortionary cost does not exist, Ricardian equivalenceholds. When tax has distortionary costs, a higher tax rate leads to a larger welfare loss.
For this reason the fiscal authority should keep the tax rate as smooth as possible. For
example, the tax smoothing theory argues that when there is a temporary big fiscal
demand, government should choose a persistent, small tax increases and issue a bond,rather than immediately passing a large tax increase. As a result, the fiscal deficit will
increase during a period of high fiscal demand.
Barro (1979) developed the tax smoothing theory under the real economy without
the consideration of money. Bohn (1990), Chari, Christiano and Kehoe (1991) argued
that when the price was flexible in a monetary economy, it was preferable to raise theinflation rate to correspond to a temporary increase in fiscal demand, which is contrary-5-

to the discussion of the real economy. Beningo and Woodfored (2003), Schmit-Grobeand Uribe (2004) and Siu (2004) examined the tax smoothing theory when priceadjustment was not flexible. In the case of sticky price adjustment in a monetary
economy, the adjustment of fiscal shock through the manipulation of the inflation rateshould lead to a change in income, thus possibly deteriorating the public welfare level.
The implication for price stability critically depends on price adjustment speed. Underthe reasonable price adjustment speed, price stability is still an important policy concern
for the central bank, even if policy makers take account of government budget.

2.3 Solvency of the consolidated government
In order for the government to be solvent, the future government debt should
satisfy the No-Ponzi Game (NPG) condition, which prohibits the real value ofgovernment debt from growing more than the discount rate. When the fiscal authority
and the central bank independently determine policy variables, an important question iswhich is responsible for guaranteeing the solvency of the government. Sargent andWallace (1981) is an influential study on this topic, and many studies followed it. There
are three ideas about how the intertemporal budget constraint of the consolidated
government should be satisfied through a conduct of monetary and fiscal policy.
(1. Monetarist theory of inflation) The central bank independently determines thegrowth rate of money. Fiscal authority passively adjusts a primary balance, and assures
the solvency of the budget.
(2. Fiscal theory of inflation) The fiscal authority independently determines a
primary balance other than seigniorage, and the central bank passively adjusts thegrowth rate of money, and guarantees the solvency of the budget.
(3. Fiscal theory of the price level) The central bank and fiscal authority
independently determine their respective policy variables, and the price level is adjusted
to guarantee the solvency of the budget. This idea has recently become a hot issue.2
The first is a widely accepted idea. Sargent and Wallace (1981) extensively
discussed the second idea, and many studies followed it. When evaluating the2

Leeper (1991), Sims (1994) and Woodford (1994, 1995) are classical studies that
advocate the fiscal theory of the price level. Critical views to this theory are found in
Buiter (1999) and McCallum (2001).
-6-

plausibility of these theories, it is natural to think that fiscal policy should be adjusted,
especially when we take into account of the quantitative impact of policy variables on
the government budget. Table 1 calculates a primary balance and seigniorage of the last
15 years in Japan. While the change in primary balance is several percents of GDP, thechange in seigniorage is one digit smaller. Therefore, it would be very difficult to use
seigniorage for the purpose of offsetting a change in the primary balance. Furthermore,a growth of seigniorage should be accompanied by a steep growth of inflation. Even if arequired seigniorage is several percents of GDP, the economy would suffer fromexorbitant inflation. Therefore, the fiscal authority should be responsible for thesolvency.

2.4 Fiscal policy under the new Keynesian framework
Log-linearizing (6) around the steady state and rearranging it yields

[

]

[

]

bˆt −1 − sbπ t − sbσ −1 y t + f t = by y t + bτ (τˆt − τˆt* ) + βEt bˆt − sbπ t +1 − sbσ −1 y t +1 + f t +1 ,(7)
where bˆt ≡ (bt − b ) Y

is the deviation of public debt from the steady state

denominated by the steady state output, f is a set of shocks affecting the budget of thegovernment, and sb ≡ s Y is the ratio of public debt to the output in the steady state. A
variable with a bar stands for its steady state level. The derivation of (7) is described by
Benigno and Woodford (2003).
The utility of the representative consumer depends on consumption and leisure.
From the model which derived (1), the second-order approximation of welfare can be
written as∑ β [π + λy ] .
∞

t =0

t

2
t

2
t

(8)

where λ is a parameter. Since the behavior of price adjustment and economic agents
have a micro foundation, it is natural that the objective function of the monetary and-7-

Table 1: Primary Balance of General Government and Seigniorage(Percent)

Year

（A)
Primary balance（C)
Seigniorage（D)
Growth rate ofmonetary base

1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003

-3.1
-2.6
-2.1
-1.3
-0.2
0.7
1.2
1.8
2.9
3.1
3.7
3.4
0.2
-1.7
-3.0
-3.7
-3.5
-2.6
-10.0
-6.3
-5.2
-5.3
-6.9
-6.1

0.6
0.7
0.0
0.6
0.3
0.4
0.5
0.6
0.9
0.9
0.9
0.6
0.0
-0.1
0.3
0.4
0.5
0.7
0.8
0.8
1.2
0.5
2.2
3.8

8.7
10.1
0.3
7.7
4.9
5.8
6.4
8.3
12.3
11.0
11.4
7.6
-0.3
-0.9
4.0
4.5
6.0
7.9
8.2
7.4
9.7
3.8
14.7
21.4

Note）All numbers are based on fiscal year. (A) and (B) are apercent of GDP. (A) Primary balance of general government iscalculated as net lending plus property income paid minus
property income received. (B) Seigniorage is calculated as a
product of the growth rate of monetary base and the averagestock of monetary base.
Source) (A) National Accounts, Cabinet Office. (C) for
monetary base, Bank of Japan.

fiscal policy should be based on the individual’s utility function.3
Lagrangian of the consolidated government can then be written as

[

]

∞
⎧1
E0 ∑ β t ⎨ π t2 + λy t2 + ϕ 1t [π t − κy t − ψτˆt − βπ t +1 ]⎩2
t =0
+ ϕ bˆ − s π − s σ −1 y − (b y + b τˆ ) − β bˆ − s π
2t

[

t −1

b

t

b

t

y

t

(

τ t

t

b

t +1

− sbσ y t +1
−1

)]}

.

(9)

Differentiating (A.12) with respect π , y ,τˆ, b , we obtain the first-order conditions:

π t + (ϕ 1t − ϕ1,t −1 ) + sb (ϕ 2 t − ϕ 2,t −1 ) = 0(10.a)

λyt − κϕ1t − [by + sbσ −1 ]ϕ 2 t + sbσ −1ϕ 2,t −1 = 0(10.b)− ψϕ 1t + bτ ϕ 2 t = 0(10.c)

ϕ 2 t = Etϕ 2,t +1(10.d)

Due to the structure of the above equations, monetary authorities must be aware of
fiscal concerns such as the impact of fiscal policy variables on the optimization problem
and the impact of monetary policy variables on the budget equation of the consolidated
government.
With the aid of research by Benigno and Woodford (2003) and Eggertsson andWoodford (2004), I will examine specific cases where monetary authorities are notconcerned with fiscal responsibilities.

(a) Tax rate is not flexible and cannot be frequently adjusted.
If the tax rate is difficult to adjust and cannot be use as an instrument ofstabilization policy, (10.c) is not a part of optimality conditions. In this case, taking thefirst difference of (10.b) and substituting it into (10.a) yields

3

We assume the preference is separable between consumption and leisure. With
this assumption, the consumption Euler equation is not affected by labor supply. For aderivation of (8), see Woodford (2003).
-8-

πt +

−1
−1
⎡b
⎤
λ
( yt − yt −1 ) − ⎢ y − sb + sbσ ⎥(ϕ 2t − Et −1ϕ 2t ) + sbσ (ϕ 2t −1 − Et −1ϕ 2t −1 ) = 0 .
κ
κ ⎦
κ
⎣κ

(11)

While this procedure is an alternative method of analyzing monetary policy in order toobtain an inflation targeting rule, it clearly indicates that fiscal concern directly affects
the outcome of the targeting rule. The inflation rate should be related to the change inthe fluctuation of output from the efficient level and the shock in the marginal cost of
government spending.

(b) Tax rate is flexible and can be frequently adjusted
Utilizing (10.c), we can relate two Lagrange multipliers. As shown in Benigno andWoodford (2003),

πt +

nϕ
mϕ

π t −1 +ωϕmϕ( yt − yt −1 ) = 0 .

(12)

The coefficients of inflation and the change in y are given in their paper. The current
level of inflation is related with both past inflation and output.

(c) No public debt in the long run
Under the setting of the optimization problem, the central bank, which isconcerned with inflation, should also take into account the fact that inflation reduces thereal value of public debt. However, this interplay does not appear to concern the central
bank when it conducts monetary policy. Consider a case where this interaction isneglected. If the outstanding stock of public debt is small (or zero on average), thischannel can be neglected. When the level of public debt is zero under the steady state,sb = 0 . The optimality condition of (10.a) and (10.b) becomes simpler as

π t + (ϕ 1t − ϕ 1,t −1 ) = 0(13.a)

λyt − κϕ1t − byϕ 2 t = 0 .

(13.b)-9-

The flexible inflation-targeting rule is changed as

πt +

b
λ
( yt − yt −1 ) − y (ϕ 2t −1 − Et −1ϕ 2t −1 ) = 0 .
κ
κ

(14)

Unlike (11) or (12), the inflation rate is not affected by the past expectation error of themarginal cost of public funds.

(d) State-contingent public debts are available
When the government issues state-contingent public debts and conducts asophisticated debt management policy, it holds

ϕ 2 t = ϕ 2,t +1 .

(15)

Substituting (15) into (10.a) reduces toπt +λ( y − yt −1 ) = 0 ,
κ t

(16)

which is very similar to the well-known inflation targeting rule in the analysis ofmonetary policy. One important difference is that equation (16) cares about thedeviation of output from its efficient level.
When tax policy is used as a policy variable, it can offset the exogenous shocks ofthe new Keynesian Phillips curve. Therefore, the output can reach its efficient level.
From the viewpoint of remedying sticky price adjustment, perfect output stabilization isachieved.

(e) Monetary policy does not care fiscal concern
When the difference of natural output and efficient output is constant( y t = xt − x * ) and the central bank can commit to future policy, the optimal policy isderived through maximizing the Lagrangian- 10 -

[

]

∞
2
⎫
⎧1
E0 ∑ β t ⎨ π t2 + λ (xt − x * ) + ϕ t [π t − κxt − βπ t +1 ]⎬ .
⎭
⎩2
t =0

(17)

In order to focus on the discussion of monetary policy management, the model
assumes the difference between natural output and efficient output are constant,y t = xt − x * .
If the central bank can commit to the future policy, the following equation is
employed as the flexible inflation-targeting rule:πt +λ(x − xt −1 ) = 0 ,
κ t

(18)

or, the following equation is employed as the flexible price level-targeting rule:pt +λx =p ,
κ t(19)

where the inflation rate is π , the log of the price level as p , and the log of target pricelevel as p .

2.5 Summary of discussion
Interactions between monetary and fiscal policy crucially depends on thespecification of policy variables that fiscal policy uses. However, a general rule is thatwhen monetary policy is capable of dealing with sticky price adjustment, a primaryconcern of fiscal authority should be to remedy the resource allocation. Fiscal policy
aims at narrowing the gap between natural output and efficient output by changing the
tax rate in the new Keynesian Phillips curve. It also attempts to equalize the marginal
cost of spending. Sophisticated debt management policy may be useful for this purpose.
The unexpected inflation should not be used as a primary policy instrument of tax
smoothing.
In some cases, concerns of the central bank and the fiscal authority are to be- 11 -

interplayed. Such an example is when fiscal policy is unable to equalize the marginal
cost of spending. As shown in equation (10.a), the inflation targeting rule is aware of the
movement of the marginal cost of government spending. On the other hand, when there
are limitations to monetary policy, fiscal policy has the additional concern acting as astabilization policy.4

4Eggertsson and Woodford (2004) examined such a case when the zero lower
bound of nominal interest rate is binding.
- 12 -

3. Fiscal Version of Taylor Rule

3.1 Empirical specification and United States experience
The flexible-inflation targeting rule (18) of monetary policy can be transformed
into an instrument rule which represents the nominal short-term interest rate as afunction of the inflation rate and the output gap. 5 While fiscal policy can betransformed into this type of instrument rule, a simpler policy rule had already been
considered and empirically analyzed by Taylor (2000) in his focus on the response of
the structural (or cyclically-adjusted) budget surplus.6
The following special case of the model in Section 2 can be represented as a fiscal
version of the Taylor rule.
When sb = 0 , the dynamic equation for the real debt can be transformed as()

βEt bˆt − bˆt −1 = (1 − β )bˆt −1 − by y t − bτ (τˆt − τˆt* ) − βEt f t +1 + f t .

(20)

The left hand side of (20) corresponds to the budget deficit. The first term on the righthand side represents the interest payment of debt, the second term is a change in tax
revenue due to cyclical movements of output7, the third term is a change in tax revenue
due to the shift of tax policy, and the last two terms represent the movement of fiscal
shock. If the other terms are not changed by a cyclical movement, the structural balance
will not respond to the output gap8. One explicit case is when there is no externalchange in fiscal demands ( f = 0 ) and the tax rate is not a policy variable.
The response of the structural balance to a cyclical movement provides insightful
information of the nature of fiscal policy. Taylor (2000) conducted the following

5

They may be a current, past or expected future value, depending on thespecification of the model.
6
The structural balance of government is the financial balance when the economy
was at its natural level. It has been used as a measure of the discretionary fiscal policy.
7
Since y and the output gap (x) are different, the second term is not exactly equal
to the structural balance. However, since it measures a change in fiscal balance given
the policy, it does not correspond to the structural balance.
8 On the other hand, if the tax rate is used as a policy variable but perfect output
stabilization is impossible, the structural balance may be correlated with a cyclicalmovement of output.
- 13 -

empirical analysis, and examined the role of fiscal policy as a stabilization policy inpost WWII United States. The structural, cyclical and financial balance (a positive valuemeans a surplus) is assumed to be a linear function of the output gap. We denote astructural balance as s S , a cyclical balance as s C , and the output gap as x:s S = a0 + a1 x

(21.a)s C = a2 x .

(21.b)

Actual fiscal balance is represented ass G = a0α + (a1 + a 2 )x .

(21.c)

Three policy positions stand out when we focus on the response of the structural
budget balance to a cyclical movement of output.
(1) When the government maintains the balanced budget, a1 + a 2 = 0 . Cyclicalbalance is likely to be procyclical ( a 2 > 0 ), because during a recession, social security
expenditures increase and tax revenue decreases. Therefore, the structural balance undera balanced budget should be in a surplus during a recession ( a1 < 0 ). It is now
recognized that the balanced budget principle is not preferable because while itstimulates the economy during a boom, it dampens the economy during a recession.
Thus, policy becomes the factor which destabilizes the economy.
(2) The automatic stabilizer implies a1 = 0 ; a structural balance does not correlatewith the output gap because policy does not react to the business cycle. a 2
demonstrates the strength of the automatic stabilizer because the actual balance reflects
the movement of cyclical balance.
(3) Under an active fiscal policy, a structural balance runs a deficit during recession,and a structural balance is positively correlated with the business cycle ( a1 > 0 ).

From his analysis of the United States between 1960 and 1999, Taylor (2000)
found that, while the structural balance was hardly influenced, a 1.0 percentage point
decrease in the output gap caused a 0.5 percentage point decrease in the actual fiscal- 14 -

balance. This finding indicated that fiscal policy in the United States has acted as an
automatic stabilizer. Auerbach and Feenberg (2000) measured the quantitative
magnitude of the automatic stabilizer, and reported that an eight percent shock to GDP
was counterbalanced by the automatic stabilizer. Thus, the automatic stabilizer has
played an important role in fiscal policy for the United States.9 Romer (1999) has added
to these findings by identifying that this stabilization policy had significantly
contributed to the US’s mild business cycle.

3.2 Cross country analysis
Gali and Perotti (2003) examined the role of discretionary fiscal policy, using
OECD country data from 1980 to 2002. Their primary concern is how the Maastricht
Treaty and the Stability and Growth Pact affected fiscal management style of EU
countries. From their panel data estimation, they found that fiscal policy had become
more countercyclical in the post-Maastricht period (1992-2000). They grouped 19
countries into EMU countries (11), Non-EMU EU countries (3), and other OECD
countries (5), and ran a panel data regression for each group. They added government
debt as a ratio of potential GDP and the lagged value of the dependent variable toexplanatory variables of equation (21.a). Since the budget is planned before that fiscal
year, discretionary fiscal policy responds to the expected value of the output gap. Gali
and Perotti (2003) instrumented the output gap using past values of the output gap in acountry and another group or country (the sum of EU countries for the US, the US forother countries).
For a group of EMU countries, fiscal policy was procyclical in the pre-Maastricht
period (1980-1991), but the coefficient was not statistically significant in the
post-Maastricht period. In other two panel data, fiscal policy moved from an automaticstabilizer to countercyclical, as shown in Table 3 of their paper. They concluded that
there was a global trend in fiscal policy towards countercyclical and that the EMU
countries lagged behind it.
However, adding some qualification is in order. When the same equation isregressed with time series data of each country (Table 2 of their paper), most of the9

For further discussion of historical developments, see Schultz (1996), Stein(1996) and Stiglitz (1997).
- 15 -

coefficients of the output gap are not statistically significant at 10 percent level (14 out
of 19 countries in the post-Maastricht period). The difference in coefficients between
the periods is not significant either (15 out of 19 countries). A straightforward
interpretation of these facts is that the structural balance did not respond to the output
gap before or after the Maastricht Treaty.
Since the evidence of time series data may be imprecise due to few degrees of
freedom in regressions, I conducted alternative empirical study, aiming at increasing thedegree of freedom. To this end, I first covered a longer time span by using all ofavailable data from the data source. Regression results of three samples are presented.
The first one covers all available data, the second one consists of observations before
1989, and the last is the period from 1985 to 2003. The latter two samples areoverlapped because getting a larger degree of freedom is a prime concern. Secondly, I
confined explanatory variables by estimating equation (21.a), while Gali and Perotti(2003) included lagged values of government net debt and structural balance in a set of
explanatory variables.10
Tables 2 through 4 report regression results of equations (21.a) and (21.b) during
1966 and 2003. The structural balance, the cyclical balance and the output gap weretaken from OECD Economic Outlook Database (May 2005), and represented as apercent of potential GDP. My sample was restricted to the 21 countries OECD had
structural balance data on.11
Table 2 reports results of instrumental variables regressions. I used the one-year lagof output gap of a country and the one-year lag of the average of output gap of all
countries. In the sample after 1985, the coefficients of output gap were statisticallysignificant in Australia, Norway, Sweden and the United Kingdom. In the sample before
1989, the coefficient was not significant in 13 out of 19 countries. The number ofstatistically significant coefficients does not increase in the later period. Unlike Gali andPerotti (2003), a trend to discretionary fiscal policy is not found.
Table 3 shows results of ordinary least squares regressions. When the government
projects the output more sophisticatedly, there is a possibility that OLS estimation,
10

While I also ran the regressions that include these variables as explanatory
variables, the results were not essentially altered.
11
Unfortunately, Korea is dropped from my sample, because OECD did not
estimate a structural balance of general government.
- 16 -

Table 2: Response of Structural Balances to Output Gap in OECD Countries: Instrumental Variable Regressions

Australia
Austria
Belgium
CanadaDenmark
FinlandFranceGermany
GreeceIceland
Ireland
Italy
Japan
Netherlands
New Zealand
NorwayPortugal
Spain
SwedenUnited Kingdom
United States(A)
All periods(B)
before 1989(C)
1985-2003

0.83
0.72
-0.07
0.30
0.91
0.14
0.31

(0.24) **(0.31)(0.51)(0.29)(0.31) **(0.09)(0.21)

1.03
0.41
0.11
0.22
0.84
-0.22
0.33

(0.56) *(0.27)(0.44)(0.27)(0.37) **(0.22)(0.17) *

0.08
-0.05
-0.10
0.38
0.30
0.01

(0.40)(0.16)(0.42)(0.38)(0.36)(0.23)

0.54
-0.10
-0.72
0.63
-0.56
0.09

(0.50)(0.24)(0.70)(0.38)(0.39)(0.34)

0.00
-0.18
0.02
0.90
-0.19
0.33

(0.16)(0.11)(0.17)(0.22) **(0.19)(0.19) *

-0.64
-0.31
-0.05
1.10
-0.25
0.18

(0.22) **(0.14) *(0.14)(0.29) **(0.14)(0.15)

0.75
0.39
0.34
0.18
0.30
0.11
0.00
-0.40
-0.19
-0.24
0.21
0.41
0.54
-0.10
0.20
0.41
-0.05
0.21
0.79
0.32
0.51

(0.23) **(0.24)(0.64)(0.59)(0.24)(0.08)(0.22)(0.27)(0.72)(0.22)(0.29)(0.72)(0.47)(0.36)(0.31)(0.18) **(0.12)(0.23)(0.21) **(0.28)(0.62)Note) Numbers in parentheses are the standard error. ** and * indicate a statistically significant coefficientat 5 percent level and at 10 percent level, respectively. Instrumental variables are the one-year lag of output
gap of the estimated countrry and the one-year lag of the average of output gaps of all countries.
In (A) and (B), sample periods depend on the availability of data for each country. In (C), the sample period
is from 1992 to 2003 for Germany, and from 1988 to 2003 for New Zealand.
Source) Data are taken from OECD Economic Outlook Vol. 77 (May 2005) Database.

Table 3: Response of Structural Balances to Output Gap in OECD Countries:
Ordinary Least Squares Regressions

Australia
Austria
Belgium
CanadaDenmark
FinlandFranceGermany
GreeceIceland
Ireland
Italy
Japan
Netherlands
New Zealand
NorwayPortugal
Spain
SwedenUnited Kingdom
United States(A)
All periods(B)
before 1989(C)
1985-2003

0.53
0.14
-0.14
0.33
0.50
0.09
0.26
-0.25
0.27
-0.08
0.31
0.61
0.47
-0.11
0.40
-0.06
-0.15
0.03
0.84
-0.11
0.27

0.37
0.27
0.21
0.17
0.72
-0.41
0.27

(0.22)(0.17)(0.33)(0.20)(0.25) **(0.18) **(0.12) **

0.44
-0.10
-0.51
0.63
-0.30
-0.04

(0.34)(0.24)(0.56)(0.26) **(0.32)(0.21)

-0.58
-0.20
-0.28
1.00
-0.29
0.19

(0.20) **(0.13)(0.13)(0.27) **(0.12) **(0.11) *

0.68
0.07
0.30
0.39
0.12
0.11
-0.06
-0.25
-0.41
-0.18
0.37
0.92
0.75
-0.21
0.40
0.28
-0.05
0.08
0.82
0.45
0.49

(0.15) **(0.15)(0.38)(0.21)(0.19) **(0.08)(0.16)(0.15)(0.30)(0.12)(0.34)(0.27) **(0.27) *(0.16)(0.25)(0.14)(0.09)(0.15)(0.19) **(0.15)(0.12) **(0.19) **(0.19)(0.52)(0.41)(0.18)(0.06)(0.18)(0.14)(0.56)(0.15)(0.24)(0.61)(0.34) **(0.26)(0.25)(0.16)(0.11)(0.20)(0.18) **(0.22) **(0.40)Note) Numbers in parentheses are the standard error. ** and * indicate a statistically significant coefficientat 5 percent level and at 10 percent level, respectively. OLS estimation.
In (A) and (B), sample periods depend on the availability of data for each country. In (C), the sample period
is from 1991 to 2003 for Germany, and from 1987 to 2003 for New Zealand.
Source) Data are taken from OECD Economic Outlook Vol. 77 (May 2005) Database.

which implicitly assumes the perfect foresight of the output gap, becomes a better
approximation to the reality. In the period after 1985, the coefficient was not statisticallysignificant in 17 out of 21 countries. Based on these findings, it appears that the
majority of developed countries do not actively use fiscal policy as a stabilization policy.
While its quantitative magnitude differs among countries, fiscal policy is instead used as
an automatic stabilizer. On the other hand, a statistically significant response regarding
structural balance was found in Australia, Japan, Sweden and the United Kingdom.
Sweden’s coefficient was the most significant. In Figure 1(A), the structural balance andthe output gap in Sweden demonstrates the synchronized movement. Japan’s coefficientof 0.75 is high as well. Those of Australia and the United Kingdom follow.
OLS regression results of equation (21.b) are reported in column (A) of Table 412.
While all are statistically significant, the response of the cyclical balance differedamong countries. Nordic countries (Denmark, Finland, Norway and Sweden) and theNetherlands have large coefficients ( a 2 ). Japan has the lowest value, 0.22. Therefore,
Japan’s characteristics are unique; its structural balance responds strongly to the output
gap, while the magnitude of an automatic stabilizer is the smallest among the sample.
Table 2 also draws the OECD’s estimate of the elasticity of total balance with respect tothe output gap from Sources and Methods of the OECD Economic Outlook. Since thiselasticity captures the cyclical movement of fiscal balance, it is highly correlated withthe cyclical balance (as a share of GDP).

12

The constant term is added in the estimated equation. Since the response to theactual business conditions is the focus of an automatic stabilizer, I do not instrument theoutput gap here.
- 17 -

Figure 1(A): Structural Balance and Output Gap, Sweden
64Percent of GDP

2
0
1985

1987

1989

1991

1993

1995

1997

-2
-4
-6
-8
-10
structural balance

output gap

1999

2001

2003

Figure 1(B) Structural Balance and Output Gap, Japan
6
4

Percent of GDP

2
0
1985

1987

1989

1991

1993

1995

1997

-2
-4
-6
-8
structural balance

output gap

1999

2001

2003

Table 4: Response of Cyclical Balances to Output Gap in OECD Countries(A)
Cyclical balance

Australia
Austria
Belgium
CanadaDenmark
FinlandFranceGermany
GreeceIceland
Ireland
Italy
Japan
Netherlands
New Zealand
NorwayPortugal
Spain
SwedenUnited Kingdom
United States

0.30
0.32
0.69
0.46
0.78
0.72
0.42
0.69
0.47
0.40
0.39
0.57
0.22
0.79
0.57
0.92
0.36
0.42
0.77
0.55
0.28

(0.01) **(0.01) **(0.01) **(0.01) **(0.01) **(0.02) **(0.00) **(0.15) **(0.01) **(0.01) **(0.01) **(0.04) **(0.01) **(0.02) **(0.01) **(0.26) **(0.01) **(0.01) **(0.01) **(0.06) **(0.00) **(B)
Elasticity offiscal balance
0.25
0.30
0.61
0.39
0.75
0.64
0.42
0.51
0.44
0.31
0.48
0.26
0.64
0.53
0.63
0.39
0.40
0.68
0.50
0.25

Note) Numbers in parentheses are the standard error. ** and* indicate a statistically significant coefficient at 5 percent
level and at 10 percent level. The sample period is from 1985
to 2003 except Germany and New Zealand. The sample
period is from 1991 to 2003 for Germany, and from 1987 to
2003 for New Zealand. (A) is an estimated coefficient ofcyclical balance when it is regresed on the output gap.
Cyclical balance is obtained by deducting the structuralbalance from fiscal balance. (B) is OECD's estimate of theelasticity of fiscal balance to output.
Source) (A) Data are taken from OECD Economic Outlook
Vol. 77 (May 2005) Database. (B) Sources and Methods of

4. Japanese experiences

It is unwise to regard the regression results in Tables 2 and 3 as the definite pictureof fiscal management in developed countries. The following reservations must be stated.
The Output gap is estimated with a significant margin of error. As pointed out inOrphanides (2000), the estimate of the output gap may be sensitive to when it wasestimated. Since I confined the sample to the most recent years, the data contains alimited number of cycles. The estimated coefficient may not reflect a systematic
response to the business cycle but instead reflect a particular episode, one which is not
relevant to stabilization policy. The response of the structural balance to changes in theeconomy can be delayed and our uniform specification of the estimated equation does
not capture the differing lag structures of each country. Therefore, this kind ofcross-country study should be supplemented by a careful analysis of a particularcountry.

4.1 Alternative analysis of fiscal Taylor ruleThis section takes a closer look at the Japanese situation. I found in the last sectionthat Japanese fiscal policy takes a unique position when compared to a majority ofOECD countries. To further substantiate my results, it is necessary to execute ananalysis using alternative data. If the secondary study does not coincide with my results,then the cross-country study produced a more cohesive result for developed countries.
But, if the analysis reveals that Japan really is a distinctive case, then my findings on avariety of fiscal policy stances becomes more secured.
A natural level of output or structural balance of the government has beenoccasionally estimated by Japanese researchers (for example, Yui, 1983, Homma et. al,1987, Yoshida and Fukui, 2000, and Nishizaki and Nakagawa, 2000) and the Cabinet
Office (formerly Economic Planning Agency). These studies aid in our examination of
the robustness of the findings in Section 3.
Table 5 draws on my previous paper’s empirical analysis (Iwamoto, 2002). The
methodology is the same, and the regression analysis of the preceding section was used.
The data was taken from different sources such as the Economic Planning Agency’s
Economic White Paper (2000), Nishizaki and Nakagawa (2000), OECD Economic- 18 -

Table 5: The Response of Structural and Cyclical Balances to Output gap

SourcePeriodStructural Balance

Cyclical Balance

Economic Planning Agency (2000)
1983-1998

1.09(0.23)

0.35(0.04)

Nishizaki and Nakagawa (2000)
1983-1999

0.77(0.13)

0.36(0.01)

OECD (2001)
1985-2000

0.37(0.45)

0.20(0.01)

Yoshida and Fukui (2000)
1983-2000

0.38(0.52)

0.33(0.05)Note) Numbers are an estimated coefficient. Numbers in parenthesis are thestandard error.
Source) Iwamoto (2002).

Outlook No. 70 (2001), and Yoshida and Fukui (2000). I chose to report the estimation
using the OECD data from a previous issue of OECD Economic Outlook, because one
can check whether regression results vary according to the time and period measured.
As for the reaction of structural balance, the coefficient was not significant in both
OECD (2001) and Yoshida and Fukui (2000). On the other hand, the Economic
Planning Agency (2000) and Nishizaki and Nakagawa (2000) obtained statisticallysignificant coefficients of 0.77 to 1.09 respectively.
The difference in the results stems from the difference in the estimated movementof the output gap in the latter half of 1990s. Figure 2(A) shows the movement of theoutput gap used in Table 5. The output gap of OECD (2001) and Yoshida and Fukui(2000) declined after 1988, while data from the Economic Planning Agency (2000) andNishizaki and Nakagawa (2000) showed that the output gap improved in the latter halfof 1990s. Figure 1(B) shows that the structural balance has deteriorated steadily in
1990s, except for 1997 when financial structural reform was enacted. Therefore, while
structural balance and output level were synchronized according to the Economic
Planning Agency (2000) and Nishizaki and Nakagawa (2000), data from the OECD
(2001) and Yoshida and Fukui (2000) claimed that the two variables diverged in later
periods of the sample. That is why the former had a statistically significant coefficientwhile the latter did not.
Since the estimation of the output gap influences the regression, one has todetermine the most reliable estimate of the output gap. The Economic Planning Agency(2000) and Nishizaki and Nakagawa (2000) employed a careful estimation method, andit appears to be consistent with other business indicators. Therefore, taking their results
into an account, my research shows that the Japanese structural balance fundamentally
responds to the output gap. However, this finding requires further qualification as adriving force of the structural balance might not be included in the above regression
analysis. Another possible explanation of the co-movement of the structural balance andthe output gap is that they were driven by a trend which was headed in the same
direction. For example, although both the structural balance and the output gap showed
long-term improvement in the 1980’s, they could have been driven by different factors
such as fiscal reconstruction.
Asako, Ito and Sakamoto (1991) analyzed the cause of the chronic budget deficit- 19 -

Figure 2(A) Output Gap, Japan
5.0
4.0

Percent of GDP

3.0
2.0
1.0
0.0
-1.0

1983

1985

1987

1989

1991

1993

1995

1997

1999

-2.0
-3.0
-4.0
-5.0
Economic Planning Agency (2000)
OECD (2001)

Nishizaki and Nakagawa (2000)
Yoshida and Fukui (2000)

Figure 2(B) Structural Balance of Central Government, Japan
4.0
2.0

Percent of GDP

0.0
1983

1985

1987

1989

1991

1993

1995

1997

1999

-2.0
-4.0
-6.0
-8.0
-10.0
Economic Planning Agency (2000)
OECD (2001)

Nishizaki and Nakagawa (2000)
Yoshida and Fukui (2000)

which started in the latter half of the 1970’s. They found that two factors played an
important role in creating the deficit. First, the inertia of nominal spending growth wasstrong enough to continue after the decline of nominal economic growth. The other isthat the policymakers were optimistic about introducing a new sales tax, even though
the structural deficit followed the economic downturn. Their findings imply cyclicalfactors did not largely impact the budget deficit.
Homma et al. (1987) attempted to eliminate the influence of a long-term trend by
taking a first-order difference of each variable. Observations from 1970 to 1983 showedthat the structural balance and the output gap only moved in opposite directions from1970-73. The remainder of the time the structural balance and output gap moved
together. However, Homma et al. thought that fiscal policy actively responded to thebusiness cycle. They interpreted that the comovement of the structural balance andoutput gap was caused by the fact that there is lag time when implementing
discretionary policy.13

4.2 Regime shift in 2001
In spring of 2001, Mr. Junichiro Koizumi, who favored emphasizing fiscal
adjustment, became prime minister. A new idea of fiscal management was formulated

13

Among the existing literature of Japanese fiscal policy, there are contrasting
views on whether Japanese fiscal policy has played an active role in stabilizing the
economy. Noguchi (1983) provocatively argued that Japan had seldomly taken
Keynesian policy since 1955. He confined Keynesian policy on an expansionary fiscal
policy, and pointed out that such a policy was only enacted in FY 1965 Supplementary
Budget.
Okazaki (1998) took an opposing view. He put emphasis on “stabilization,” andfocused on a broader policy by including contractionary policies. He pointed out that
discretionary fiscal policy was actively used since 1965 and had been occasionally used
before 1965. In 1980’s, when the fiscal reconstruction became a top priority, economic
stimulus measures in the recession period became mild. However, he regarded thisperiod as exceptional. He also pointed out that the reliance of discretionary policy wascaused by the fact that a Keynesian idea had widely infiltrated the policy makers.
Two points may contribute to creating these different views. First, They focused on
different policies. Okazaki (1998) included the contractionary policy and observed that
it was widely taken up during the high growth era, while Noguchi (1983) limited
Keynesian policy to the expansionary policy. Secondly, narrative analysis can be
influenced by subjective judgment.
- 20 -

and described in the Preliminary Report14 of the Fiscal System Council.
The Report summarized the experience of fiscal policy after the collapse of the“bubble economy” as:“During this period Japan implemented a total of 11 economic stimulus packages(a scale of activity totaling more than 130 trillion yen) as part of supplementarybudgets. Nevertheless, Japan's economic growth rate has generally remained sluggish
and a recovery centered on private demand was seen only for very short periods.
The problems concerning fiscal management during this period wereconcentrated in two areas.
The first is that by focusing unduly on the problem of demand shortage as thecause of economic stagnation, the government underestimated the seriousness of the
non-performing loan problem in the financial system. …
The second problem is that from a viewpoint of economic stabilization(economic adjustment), the government relied too heavily on the use of expansionary
fiscal policy. Two factors acting as restrictive conditions when giving fiscal policy aneconomic stabilization function are (a) not to sacrifice resource allocation efficiency
and (b) ensure that it is possible to maintain the fiscal policy (sustainability). In
addition fiscal policy has the defect of being less flexible than monetary policy. It
must therefore be said that during the 1990s, Japan came to rely too excessively on
fiscal policies that exceeded the limits permitted by these restrictive conditions.
As a result of these problems, the central government's efforts failed to achieve
the expected intent of lifting the economy. They also left fiscal policy itself with twoserious structural problems by (a) reducing the confidence in resource allocation
efficiency and (b) fanning doubts with regard to the sustainability of fiscal stimulus.”
Its very critical stance to the past policy action was very unique and impressive,
because the government has been always reluctant to admit that they made a mistake.
After the report reviewed the past experiences, it tried to set a new fiscal
management style that performed as a stabilization policy. The Report said“(T)he government in Japan as well should use monetary policy principally for
its economic stabilization function, and use fiscal policy for its resource allocation
function while maintaining fiscal discipline. Fiscal policy has the function of easing
business fluctuations because of its automatic stabilization mechanism (“built-in
stabilizers”) supplementing this with discretionary use of fiscal15 policy should be
limited to only those situations where a recession is extremely serious and the latitude
for exercising monetary policy is extremely limited.”
4.3 Three issues of Japanese Fiscal Policy
Japanese fiscal policy must tackle three difficult problems.
14

From unknown reasons, no final report was released.
In the English text of this Report, this word was read as “monetary.” From theoriginal Japanese text, it should have been “fiscal.” I then corrected it here.
15- 21 -

(a) Sustainability of the budget
While the actual fiscal policy after FY2002 followed the Preliminary Report tosome extent, it did not follow it in all aspects. A positive phenomenon resulting from thereport was the dramatic decline of public works in the following years. However, thegovernment cut taxes in FY 2002, and the budget continued to run a huge deficit. From
Figure 1(B), we can see that the structural balance did not dramatically improve.
With the economy in a weak condition, there was strong pressure to practice amore expansionary fiscal policy. While the resulting policy change was not intended tofurther expand Japan’s fiscal stance, it did not stop expansionary fiscal policy fromoccurring. This has become a problem. Years of aggressive expansionary policy haveled citizens to believe this is not an extreme policy position.
As shown in Figure 3, the accumulation of government debt has not subsided. The
way to rescue our budget is obvious. The government has to improve its primarybalance and steadily decrease the ratio of government debt to GDP. However, it willtake time to achieve a primary surplus because the primary deficit of central and local
governments combined is at 4 percent of the GDP (FY2004).
In the beginning of 2002, the Japanese government aimed at achieving a budget
surplus by early 2010. Today the target is set at FY2012. This target is consistent withthe recent trends, which show an increase of the primary surplus by 0.5 percent of GDP
each year. After that, it will be necessary to increase the surplus to decrease the amountof government debt. Fiscal adjustment is a time-consuming process.

(b) Monetary policy
The Report from the Fiscal System Council stated that a discretionary use of fiscal
policy should be limited to cases where monetary policy options are extremely limited.
With the nominal interest rate hitting its lower bound, the current Japanese situation
may be judged as such a situation. However, a traditional style of fiscal expansion is nota serious choice, given the huge size of the deficit. Other fiscal policy options have been
extensively discussed.
When contemplating the possibility of a zero nominal interest rate, twointerpretations come to the forefront. First is the liquidity trap, where the natural interest
rate is temporarily negative. Feldstein (2002), Auerbach and Obstfeld (2004) and- 22 -

Figure 3: Gross Financial Liabilities of General Government, Japan
180

140
120
100
80

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

60
1987

Percent of GDP

160

Eggertsson and Woodford (2003) examined such a possibility where the policy
gradually raised the consumption tax in order to create inflation and escape from theliquidity trap. The other is a “deflationary trap,” in which the natural interest rate is
positive, but a persistent zero interest rate sustains an equilibrium deflation. Amongothers, Benhabib, Schmit-Grohe and Uribe (2002), Eggertsson and Woodford (2003)
and Iwamoto (2005) have discussed the possibility that a non-Ricardian policy could
rescue the economy from such a trap. Iwamoto (2005) argued that a necessarymoney-financed tax cut would be around 2 trillion yen. The puzzle is whether or not thecurrent massive budget deficit is non-Ricardian enough to escape from a deflationary
trap.

(c) Magnitude of an automatic stabilizer
When fiscal policy is confined to an automatic stabilizer, its magnitude becomes
important. According to OECD’s estimates as well as my analysis, Japan’s automaticstabilizer has the lowest magnitude. Table 6 highlights the OECD’s estimate of theelasticity of each budget item with respect to output between Japan and the OECDaverage. The elasticity of corporate tax revenue is the largest in Japan. However, theelasticity of other budget items is quite low; for example, the elasticity of other tax
revenues and social security contributions are the lowest or the second lowest. A lower
share of tax revenues to income may be the reason for this low elasticity. Structural tax
reform, a tax increase, and the restoration of fiscal discipline will be necessary in thenear future.

- 23 -

Table 6: Elasticities of Budget Items with Respect to the Output Gap

Elasticity

Japan

OECD average

Corporate tax
Personal tax
Indirect tax
Social Security tax
Current expenditure
Total balance

2.1
0.4
0.5
0.3
-0.1
0.26

1.24
1.05
0.89
0.82
-0.21
0.47

Source) Sources and Methods of the OECD Economic
Outlook , OECD Economics Department.

5. Conclusion

This paper explored how monetary policy and fiscal policy synchronize andinteract as a stabilization policy. Interactions between monetary and fiscal policy
crucially depend on the specific policy variables utilized by fiscal policy. However, ageneral rule is that when monetary policy is capable of dealing with sticky priceadjustment, a primary concern of fiscal authority should be to remedy resource
allocation. My regression study using cross-country data shows that a majority ofOECD countries employs fiscal policy as an automatic stabilizer.
Japan has relied heavily on discretionary fiscal policy. In the late 1990s, theJapanese government attempted a very aggressive fiscal expansion in order to recover
the economy as it was suffering from a domestic and international financial crisis. The
resulting stagnant economy and inefficient spending has led policymakers to change
their thoughts regarding fiscal policy. However, as I discussed throughout the paper, thecomplete implementation of monetary policy in Japan will take considerable time.

- 24 -

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