Fiscal-Monetary Policy Coordination in China Under Federal Reserve Policy Shocks

Abstract

Enhancing coordination between fiscal and monetary policies is a top priority in deepening China’s macroeconomic regulation system reform. This paper examines the dynamic effects of strengthening fiscal-monetary policy coordination under Federal Reserve monetary policy shocks by constructing a New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) model that incorporates capital controls and foreign exchange intervention features, while integrating policy coordination approaches such as fiscal deficit monetization and financial support for fiscal expansion.

The study finds that: First, relying solely on monetary policy cannot mitigate the suppressive effect of Federal Reserve interest rate hikes on China’s aggregate demand, necessitating coordinated efforts between fiscal and monetary policies. Second, the policy coordination approach of fiscal deficit monetization fails to effectively alleviate the adverse impact of Federal Reserve rate hikes on China’s economy; instead, it amplifies macroeconomic fluctuations and triggers a “debt-deflation trap”. Third, the policy coordination approach of financial support for fiscal expansion demonstrates effects such as conserving policy space and stabilizing economic fluctuations. Further analysis from the perspective of structural tax cuts shows that combining financial support for fiscal expansion with structural tax cuts positively enhances social welfare. Additionally, counterfactual simulations indicate that the policy coordination approach of financial support for fiscal expansion effectively mitigates the negative impact of Federal Reserve rate hikes on China, ensuring economic stabilization and recovery.

The marginal contributions of this paper are threefold. First, it examines fiscal-monetary policy coordination under Federal Reserve rate hike shocks while incorporating capital controls and foreign exchange intervention. Second, it moves beyond the simplified settings of traditional DSGE models for fiscal-monetary policy coordination by integrating fiscal deficit monetization and financial support for fiscal expansion into the NK-DSGE framework and comparing their performance across multiple dimensions. Third, under heterogeneous household settings, it employs weighted average consumption compensation variation as a measure of social welfare to quantify the welfare-enhancing effects of combining financial support for fiscal expansion with structural tax cuts.

The findings provide important policy implications for deepening China’s macroeconomic regulation system. First, strengthening fiscal-monetary policy coordination can form a powerful policy synergy. Second, innovating the policy coordination approach of financial support for fiscal expansion offers advantages such as conserving monetary policy space and effectively stabilizing economic fluctuations, providing robust support for growth. Third, policymakers should adopt a cautious stance toward fiscal deficit monetization—avoiding blind adherence to Western theories in favor of fiscal policies aligned with China’s actual development needs. Lastly, promoting growth through structural tax cuts, particularly when combined with financial support for fiscal expansion, can positively enhance social welfare. Further increasing structural tax cuts may also foster a virtuous cycle of mutually reinforcing consumption and investment.