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An Equilibrium Approach to the Term Structure of Interest rates with the Interaction between Monetary and Fiscal Policy

In this paper I jointly derive the stochastic process of the price level, the inflation rate, the nominal and real term structures, as function of monetary, fiscal and technological parameters within a general equilibrium framework. The novelty of the present approach is given by the possibility of obtaining closed form solutions for all the variables and by the explicit design of fiscal policy as a crucial parameter in addition to monetary policy. Thus, as stated from FTPL, inflation is not uniquely a monetary phenomenon, but also fiscal policy plays a crucial role in determining the position of the nominal spot curve and term structure of intererest rates. The risky factors of nominal and real term structures depend upon different factors, when the utility function is strongly separable in both output and real money balances. If not, monetary and fiscal parameters affect only nominal equilibrium. The principal realtionships derived of the model are then simulated for different values of policy parameters. The main conclusion is that fiscal policy parameters play a crucial role in term structure patterns, as recently observed by the performance of nominal rates for some countries (like Italy, fore example) after having joined the EMU.

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Paper provided by Dipartimento Scienze Economiche, Universita' di Bologna in its series Working Papers with number 410.

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Date of creation: 2001
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Handle: RePEc:bol:bodewp:410
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  1. Danthine, Jean-Pierre & Donaldson, John B, 1986. "Inflation and Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 54(3), pages 585-605, May.
  2. Marshall, David A, 1992. " Inflation and Asset Returns in a Monetary Economy," Journal of Finance, American Finance Association, vol. 47(4), pages 1315-42, September.
  3. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  4. Stulz, Rene M, 1986. " Asset Pricing and Expected Inflation," Journal of Finance, American Finance Association, vol. 41(1), pages 209-23, March.
  5. Constantinides, George M, 1992. "A Theory of the Nominal Term Structure of Interest Rates," Review of Financial Studies, Society for Financial Studies, vol. 5(4), pages 531-52.
  6. Breeden, Douglas T., 1986. "Consumption, production, inflation and interest rates : A synthesis," Journal of Financial Economics, Elsevier, vol. 16(1), pages 3-39, May.
  7. Giancarlo Corsetti & Paolo Pesenti, 1999. "Stability, Asymmetry, and Discontinuity: The Launch of European Monetary Union," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 30(2), pages 295-372.
  8. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  9. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
  10. 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.
  11. M. Marzo, 2001. "Monetary and Fiscal Policy Interactions: the Impact on the Term Structure of Interest Rates," Working Papers 409, Dipartimento Scienze Economiche, Universita' di Bologna.
  12. Canzoneri, Matthew B & Cumby, Robert & Diba, Behzad, 1998. "Fiscal Discipline and Exchange Rate Regimes," CEPR Discussion Papers 1899, C.E.P.R. Discussion Papers.
  13. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
  14. John H. Cochrane, 2000. "Money as Stock: Price Level Determination with no Money Demand," NBER Working Papers 7498, National Bureau of Economic Research, Inc.
  15. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-84, March.
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