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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. 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.
  2. Albert Marcet & Albert Scott, 2007. "Debt and Deficit Fluctuations and the Structure of Bond Markets," Working Papers 332, Barcelona Graduate School of Economics.
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  8. Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Optimal simple and implementable monetary and fiscal rules," Working Paper 2007-24, Federal Reserve Bank of Atlanta.
  9. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers 200106, Rutgers University, Department of Economics.
  10. John H. Cochrane, 2000. "Money as Stock: Price Level Determination with no Money Demand," NBER Working Papers 7498, National Bureau of Economic Research, Inc.
  11. Martin Uribe & Stephanie Schmitt-Grohe, 2001. "Optimal fiscal and monetary policy under sticky prices," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  12. 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.
  13. John H. Cochrane, 1998. "A Frictionless View of U.S. Inflation," NBER Working Papers 6646, National Bureau of Economic Research, Inc.
  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. 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. 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.
  17. Betty Daniel, 2000. "A Fiscal Theory of Currency Crises," Econometric Society World Congress 2000 Contributed Papers 0535, Econometric Society.
  18. Ricardo Nunes, 2010. "Inflation Dynamics: The Role of Expectations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(6), pages 1161-1172, 09.
  19. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  20. Michael Kumhof & Evan Tanner, 2005. "Government Debt; A Key Role in Financial Intermediation," IMF Working Papers 05/57, International Monetary Fund.
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