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Simple Monetary Rules under Fiscal Dominance


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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  1. Pierpaolo Benigno & Michael Woodford, 2006. "Optimal Inflation Targeting Under Alternative Fiscal Regimes," Working Papers Central Bank of Chile 407, Central Bank of Chile.
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  13. 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.
  14. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Optimal Fiscal and Monetary Policy Under Sticky Prices," NBER Working Papers 9220, National Bureau of Economic Research, Inc.
  15. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
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  19. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
  20. Michael Kumhof & Evan Tanner, 2005. "Government Debt: A Key Role in Financial Intermediation," IMF Working Papers 05/57, International Monetary Fund.
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