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Simple Monetary Rules under Fiscal Dominance

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  • MICHAEL KUMHOF
  • RICARDO NUNES
  • IRINA YAKADINA

Abstract

This paper asks whether interest rate rules that respond aggressively to inflation, following the Taylor principle, are feasible in countries that suffer from fiscal dominance. We find that if interest rates are allowed to also respond to government debt, they can produce unique equilibria. But such equilibria are associated with extremely volatile inflation. The resulting frequent violations of the zero lower bound make such rules infeasible. Even within the set of feasible rules the welfare optimizing response to inflation is highly negative. The welfare gain from responding to government debt is minimal compared to the gain from eliminating fiscal dominance. Copyright (c) 2010 The Ohio State University No claim to original US government works.

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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 42 (2010)
Issue (Month): 1 (02)
Pages: 63-92

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Handle: RePEc:mcb:jmoncb:v:42:y:2010:i:1:p:63-92

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Web page: http://www.blackwellpublishing.com/journal.asp?ref=0022-2879

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Cited by:
  1. Shabbir, Safia, 2012. "Balance Sheet Channel of Monetary Policy and Economic Growth under Fiscal Dominance: Evidence from Pakistan," MPRA Paper 41496, University Library of Munich, Germany.
  2. Danciulescu, Cristina, 2014. "Macroeconomic equilibrium and welfare under simple monetary and switching fiscal policy rules," Economic Modelling, Elsevier, vol. 36(C), pages 58-68.
  3. Ali, Syed Zahid & Anwar, Sajid, 2013. "Inflation and interest rates in the presence of a cost channel, wealth effect and agent heterogeneity," Economic Modelling, Elsevier, vol. 31(C), pages 286-296.

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