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Simple Monetary Rules under Fiscal Dominance

Listed author(s):
  • 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
Handle: RePEc:pra:mprapa:4462
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  1. Michael Kumhof & Shujing Li & Isabel Yan, "undated". "Balance of Payments Crises Under Inflation Targeting," Working Papers 00020, Stanford University, Department of Economics.
  2. 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.
  3. Betty Daniel, 2000. "A Fiscal Theory of Currency Crises," Econometric Society World Congress 2000 Contributed Papers 0535, Econometric Society.
  4. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1.
  5. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," CEPR Discussion Papers 2942, C.E.P.R. Discussion Papers.
  6. Cochrane, John H., 2005. "Money as stock," Journal of Monetary Economics, Elsevier, vol. 52(3), pages 501-528, April.
  7. John H. Cochrane, 2000. "Money as Stock: Price Level Determination with no Money Demand," NBER Working Papers 7498, National Bureau of Economic Research, Inc.
  8. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
  9. Ricardo Nunes, 2010. "Inflation Dynamics: The Role of Expectations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(6), pages 1161-1172, 09.
  10. Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," CEPR Discussion Papers 4334, C.E.P.R. Discussion Papers.
  11. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
  12. Pierpaolo Benigno & Michael Woodford, 2006. "Optimal Inflation Targeting Under Alternative Fiscal Regimes," Working Papers Central Bank of Chile 407, Central Bank of Chile.
  13. Michael Kumhof & Evan C Tanner, 2005. "Government Debt; A Key Role in Financial Intermediation," IMF Working Papers 05/57, .
  14. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Staff Report 147, Federal Reserve Bank of Minneapolis.
  15. 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.
  16. 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 381-399.
  17. John H. Cochrane, 1998. "A Frictionless View of U.S. Inflation," CRSP working papers 479, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  18. 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.
  19. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  20. 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.
  21. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
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