This paper studies the interdependence between fiscal and monetary policy in a DSGE model with sticky prices and non-zero trend inflation. We characterize the fiscal and monetary policies by a rule whereby a given fraction k of the government debt must be backed by the discounted value of current and future primary surpluses. The remaining fraction of debt is backed by seigniorage revenues. When k = 1, there is no fiscal dominance, since the fiscal authority backs all debt and accommodates (independent) monetary policy, by adjusting current or future primary surpluses to satisfy the government’s intertemporal budget constraint. If k = 0, all debt is backed by the monetary authority and there is complete fiscal dominance. A continuum of possibilities lies between these two polar cases. We numerically show that: 1) the degree of fiscal dominance, as measured by (1 - k), is positively related to trend inflation, and 2) when prices are sticky, k has significant effects on the business cycle dynamics. The model is estimated using Bayesian techniques. Estimates of k imply a high degree of fiscal dominance in both Mexico and South Korea, but almost no fiscal dominance in Canada and the U.S. The country-specific estimates of the structural parameters are used in a second-order approximation of the equilibrium around the deterministic steady-state to evaluate the welfare costs of fiscal dominance. Results suggest significant welfare losses for countries with high degrees of fiscal dominance.
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Paper provided by Bank of Canada in its series Working Papers with number
08-28.
Find related papers by JEL classification: E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization
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