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Simple Monetary Rules under Fiscal Dominance

  • Michael, Kumhof
  • Ricardo, Nunes
  • Irina, Yakadina

This paper asks whether an aggressive monetary policy response to inflation is feasible in countries that suffer from fiscal dominance, as long as monetary policy also responds to fiscal variables. 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. But following such rules results in extremely volatile inflation. This leads to very frequent violations of the zero lower bound on nominal interest rates that make such rules infeasible. Even 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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File URL: https://mpra.ub.uni-muenchen.de/4462/1/MPRA_paper_4462.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 4462.

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Date of creation: Aug 2007
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Handle: RePEc:pra:mprapa:4462
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  1. Daniel, Betty C, 2001. "A Fiscal Theory of Currency Crises," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(4), pages 969-88, November.
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  3. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
  4. Marcet, Albert & Scott, Andrew, 2009. "Debt and deficit fluctuations and the structure of bond markets," Journal of Economic Theory, Elsevier, vol. 144(2), pages 473-501, March.
  5. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, September.
  6. Pierpaolo Benigno & Michael Woodford, 2007. "Optimal Inflation Targeting under Alternative Fiscal Regimes," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 3, pages 037-075 Central Bank of Chile.
  7. Cochrane, John H., 2005. "Money as stock," Journal of Monetary Economics, Elsevier, vol. 52(3), pages 501-528, April.
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  9. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
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  11. John H. Cochrane, 1999. "A Frictionless View of U.S. Inflation," NBER Chapters, in: NBER Macroeconomics Annual 1998, volume 13, pages 323-421 National Bureau of Economic Research, Inc.
  12. Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Optimal simple and implementable monetary and fiscal rules," FRB Atlanta Working Paper 2007-24, Federal Reserve Bank of Atlanta.
  13. Michael Kumhof & Evan C Tanner, 2005. "Government Debt; A Key Role in Financial Intermediation," IMF Working Papers 05/57, International Monetary Fund.
  14. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," CEPR Discussion Papers 2942, C.E.P.R. Discussion Papers.
  15. Shujing Li & Isabel K. Yan & Michael Kumhof, 2007. "Balance of Payments Crises Under Inflation Targeting," IMF Working Papers 07/84, International Monetary Fund.
  16. 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.
  17. John H. Cochrane, 2000. "Money as Stock: Price Level Determination with no Money Demand," NBER Working Papers 7498, National Bureau of Economic Research, Inc.
  18. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 4(3), pages 381-99.
  19. Ricardo Nunes, 2010. "Inflation Dynamics: The Role of Expectations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(6), pages 1161-1172, 09.
  20. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  21. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
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