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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: http://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. Kumhof, Michael & Li, Shujing & Yan, Isabel, 2007. "Balance of payments crises under inflation targeting," Journal of International Economics, Elsevier, vol. 72(1), pages 242-264, May.
  2. Collard, Fabrice & Juillard, Michel, 2001. "Accuracy of stochastic perturbation methods: The case of asset pricing models," Journal of Economic Dynamics and Control, Elsevier, vol. 25(6-7), pages 979-999, June.
  3. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, pages 519-546.
  4. 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.
  5. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
  6. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  7. Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Optimal simple and implementable monetary and fiscal rules," Working Paper 2007-24, Federal Reserve Bank of Atlanta.
  8. Martin Uribe & Stephanie Schmitt-Grohe, 2001. "Optimal fiscal and monetary policy under sticky prices," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  9. Michael Kumhof & Evan Tanner, 2005. "Government Debt; A Key Role in Financial Intermediation," IMF Working Papers 05/57, International Monetary Fund.
  10. Albert Marcet & Andrew Scott, 2001. "Debt and deficit fluctuations and the structure of bond markets," Economics Working Papers 558, Department of Economics and Business, Universitat Pompeu Fabra, revised Jul 2003.
  11. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
  12. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," CEPR Discussion Papers 2963, C.E.P.R. Discussion Papers.
  13. Ricardo Nunes, 2010. "Inflation Dynamics: The Role of Expectations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(6), pages 1161-1172, 09.
  14. 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, vol. 4(3), pages 381-99.
  15. 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.
  16. Pierpaolo Benigno & Michael Woodford, 2006. "Optimal Inflation Targeting Under Alternative Fiscal Regimes," Working Papers Central Bank of Chile 407, Central Bank of Chile.
  17. John H. Cochrane, 1998. "A Frictionless View of U.S. Inflation," NBER Working Papers 6646, National Bureau of Economic Research, Inc.
  18. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  19. John H. Cochrane, 2000. "Money as Stock: Price Level Determination with no Money Demand," NBER Working Papers 7498, National Bureau of Economic Research, Inc.
  20. Cochrane, John H., 2005. "Money as stock," Journal of Monetary Economics, Elsevier, vol. 52(3), pages 501-528, April.
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