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This thesis consists of three essays on the discretionary interactions of fiscal and monetary policy authorities when they stabilise a single economy against shocks in the dynamic setting. In the first essay, I investigate the stabilization bias that arises in a model of noncooperative monetary and fiscal policy stabilisation of the economy, when the monetary authority implements price level targeting but fiscal authority remains benevolent. I demonstrate that the gain in welfare depends on the level of steady state debt. If the steady state level of the government debt is relatively low, then the monetary price level targeting unambiguously leads to social welfare gains, even if the fiscal authority acts strategically and faces different objectives and has incentives to pursue its own benefit and therefore may offset some or all of monetary policy actions. Moreover, if the fiscal policymaker is able to conduct itself as an intra-period leader then the social welfare gain of the monetary price level targeting regime can be further improved. However, if the economy has a relatively high steady state debt level, the gain of the price level targeting is outweighed by the loss arising from the conflicts between the policy makers, and such policy leads to a lower social welfare than under the cooperative discretionary inflation targeting. In the second essay I study the macroeconomic effect of the interaction between discretionary monetary policy which re-optimises every period and discretionary fiscal policy which reoptimises less frequently. I demonstrate the existence of two discretionary equilibria if the frequency of fiscal policy re-optimizes annually while monetary policy adjusts quarterly. Following a disturbance to the debt level, the economy can be stabilised either in a ‘fast but volatile‘ or ‘slow but smooth’ way, where both dynamic paths satisfy the conditions of optimality and time-consistency. I study several delegation regimes and demonstrate that the policy of partial targeting the debt level results in far worse welfare outcomes relative to a strict inflation targeting policy. In the third essay, I extend the framework developed in the second essay to the case with Blanchard-Yaari type of consumers. This brings in two effects. First, an increase in debt results in higher consumption via the wealth effect, the marginal cost is higher so the need for higher interest rate and higher taxation will increase, therefore the dynamic complementarity between actions of the two policymakers become stronger. Second, higher inflation affects consumption via the average propensity to consume and this effect is likely to weaken the dynamic complementarity. I show that when the households are assigned a mortality rate, overall the first effect dominates the second. The transition paths of the economic variables back to the steady state will be more volatile and the multiple equilibriums are more likely to arise.

Price Level Targeting with Imperfect Rationality: A Heuristic Approach Vojtěch Molnár Abstract The thesis compares price level targeting and inflation targeting regimes in a New Keynesian model without rational expectations hypothesis. Economic agents instead form their expectations using heuristics-they choose between a few simple rules based on their past forecasting performance. Two main specifications of the price level targeting model are examined-the agents form expectations either about price level or about inflation, which is ex ante not equivalent because of sequential nature of the model. In addition, several formulations of the forecasting rules are considered. According to the results, price level targeting is preferred in the case with expectations created about price level under the baseline calibration; but it is sensitive to some model parameters. Furthermore, when expectations are created about inflation, price level targeting over time loses credibility and leads to divergence of the economy. On the other hand, inflation targeting model functions stably. Therefore, while potential benefits of price level targeting have been confirmed under certain assumptions, the results suggest that inflation targeting constitutes significantly more robust choice for monetary policy.