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Monetary-fiscal policy interactions when price stability occasionally takes a back seat

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  • Schmidt, Sebastian

Abstract

What are the macroeconomic consequences of a government that is limited in its willingness or ability to raise primary surpluses, and a central bank that accommodates its interest-rate policy to the fiscal conditions? I address this question in a dynamic stochastic sticky-price model with endogenous shifts between an “orthodox” and a “fiscally-dominant” policy regime. The risk of future regime shifts has encompassing effects on equilibrium. Inflation is systematically higher than it would be if fiscal policy always adjusted its primary surplus sufficiently and monetary policy was solely concerned with price stability. This inflation bias is increasing in the real value of government debt. Regime-switching probabilities are not invariant to policy. The central bank can attenuate the risk of a shift to the fiscally-dominant regime by raising the real interest rate sufficiently moderately when inflation increases. Lower fiscal dominance risk, in turn, mitigates the inflation bias. JEL Classification: E31, E52, E62, E63

Suggested Citation

  • Schmidt, Sebastian, 2024. "Monetary-fiscal policy interactions when price stability occasionally takes a back seat," Working Paper Series 2889, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20242889
    Note: 2179645
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    References listed on IDEAS

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    1. Francesco Bianchi & Leonardo Melosi, 2017. "Escaping the Great Recession," American Economic Review, American Economic Association, vol. 107(4), pages 1030-1058, April.
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    More about this item

    Keywords

    endogenous regime shifts; fiscal dominance; fiscal policy; inflation bias; monetary policy;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • 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; Treasury Policy

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