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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.

Suggested Citation

  • Michael Kumhof & Ricardo Nunes & Irina Yakadina, 2010. "Simple Monetary Rules under Fiscal Dominance," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(1), pages 63-92, February.
    • Handle: RePEc:wly:jmoncb:v:42:y:2010:i:1:p:63-92
    DOI: 10.1111/j.1538-4616.2009.00278.x
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    JEL classification:

    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General

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