Fiscal dominance and price stability
In this paper, Sebastian Schmidt analyzes the impact on inflation when a central bank accommodates its interest rate policy to the fiscal stance. He uses a stochastic New Keynesian model where: a) “fiscal policy is governed by a feedback rule for the primary surplus with an upper limit;” and b) monetary policy follows a conventional Taylor rule, but when the surplus is at its limit, the central bank keeps the policy rate below some upper bound. This framework implies endogenous policy regime shifts: from the “orthodox” policy regime where the fiscal surplus is below its limit when the economy experiences an inflationary shock, but in response to the shock, the fiscal authority raises its primary surplus, to a fiscally-dominant regime, where monetary policy increases the policy rate less aggressively, if at all, in response to sufficiently large inflationary shocks.
I show that an occasional subordination of the goal of price stability to the goal of fiscal stability may result in a systematic failure to achieve the price stability goal. Inflation may be systematically higher than it would be if fiscal policy always adjusted its primary surplus sufficiently to variations in government debt and monetary policy was solely concerned with inflation stabilization. This inflation bias, in turn, can beget an upward bias in government debt in those states of the world where the conventional dichotomy between fiscal and monetary policy holds.
Monetary-fiscal policy interactions when price stability occasionally takes a back seat
Author: Sebastian Schmidt
From: ECB
Unconventional monetary policies and fiscal sustainability
In this paper, Elenev et al. study the effect of unconventional monetary policies on fiscal sustainability. They use a general equilibrium stochastic New Keynesian model with two novel features: the first feature enables the model to generate risk premia as the economy undergoes both transitory and permanent productivity shocks which lead to a high enough market price of risk associated with these productivity shocks. The second feature is that fiscal policy does not respond continuously to the debt/GDP ratio, consistent with the post-war U.S. data.
A temporary unconventional monetary policy (UMP) mounted in response to a crisis stimulates the economy, lowers the long-run debt/GDP ratio, and substantially reduces the risk of future tax increases. UMP’s effectiveness decreases in the pre-crisis debt/GDP ratio. In contrast, permanent UMP crowds out investment and lowers long-run output.
Can Monetary Policy Create Fiscal Capacity?
Authors: Vadim Elenev, Tim Landvoigt, Patrick Shultz, Stijn Van Nieuwerburgh
From: Johns Hopkins, Wharton, Columbia GSB
