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Monetary Policy and Fiscal Limits with No-Default

This paper discusses monetary and fiscal interactions in fiscal stress with no outright default. Two distortions prevail in the economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include: a ceiling on the equilibrium Debt-to-GDP ratio; zero elasticity of tax revenues; a political intolerance of rising tax rates; A Laffer curve emerges endogenously. In equilibrium, fiscal solvency is brought about through adjustments to the level of nominal prices. Three regimes achieve this goal: FC - an interaction of a fiscal rule that targets both output and public debt with a neutral monetary policy; FD - an interaction of a fiscal rule that targets the primary deficit with an active monetary policy; FDA - an interaction of an austere fiscal rule with a passive monetary policy.

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Paper provided by University of Haifa, Department of Economics in its series Working Papers with number WP2012/6.

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Handle: RePEc:haf:huedwp:wp201206
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