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Simple Monetary Rules Under Fiscal Dominance

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Author Info
Michael Kumhof
Irina Yakadina
Ricardo Nunes

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Abstract

Is aggressive monetary policy response to inflation feasible in countries that suffer from fiscal dominance? 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. However, resulting inflation is extremely volatile and zero lower bound on nominal interest rates is frequently violated. 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 International Monetary Fund in its series IMF Working Papers with number 07/271.

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Length: 25 pages
Date of creation: 07 Dec 2007
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Handle: RePEc:imf:imfwpa:07/271

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Keywords: Monetary policy Inflation Interest rates Debt Government expenditures

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  7. 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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  8. 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)
  9. 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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  12. 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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