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Simple monetary rules under fiscal dominance

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Author Info
Michael Kumhof
Ricardo Nunes
Irina Yakadina

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Abstract

This paper asks whether an aggressive monetary policy response to inflation is feasible in countries that suffer from fiscal dominance, as long as monetary policy also responds to fiscal variables. We find that if nominal interest rates are allowed to respond to government debt, even aggressive rules that satisfy the Taylor principle can produce unique equilibria. But following such rules results in extremely volatile inflation. This leads to very frequent violations of the zero lower bound on nominal interest rates that make such rules infeasible. Even within the set of feasible rules the optimal response to inflation is highly negative, and more aggressive inflation fighting is inferior from a welfare point of view. The welfare gain from responding to fiscal variables is minimal compared to the gain from eliminating fiscal dominance.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 937.

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Date of creation: 2008
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Handle: RePEc:fip:fedgif:937

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Related research
Keywords: Fiscal policy ; Monetary policy;

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  7. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
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  8. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February. [Downloadable!] (restricted)
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  11. John H. Cochrane, 2000. "Money as Stock: Price Level Determination with no Money Demand," NBER Working Papers 7498, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  12. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under sticky prices," Journal of Economic Theory, Elsevier, vol. 114(2), pages 198-230, February. [Downloadable!] (restricted)
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  13. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  15. Marcet, Albert & Scott, Andrew, 2001. "Debt and Deficit Fluctuations and the Structure of Bond Markets," CEPR Discussion Papers 3029, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  16. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January. [Downloadable!] (restricted)
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