Monetary policy and fiscal limits with no-default

This paper discusses monetary and fiscal policy interactions that stabilize government debt. Two distortions prevail in the model economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include a ceiling on the equilibrium debt-to-GDP ratio, zero or negative elasticity of tax revenues, and a political intolerance of raising tax rates. At the fiscal limit two mechanisms restore solvency: fiscal inflation, which reduces the real value of nominal debt, and open market operations, which diminish the size of government debt held by the private sector. Three regimes achieve this goal. In all regimes monetary policy is passive. In all regimes a muted tax response to government debt is consistent with equilibrium. The propensity of a fiscal authority to smooth output is found to determine what is an acceptable response (in the form of tax rate changes) to the level of government debt, while monetary policy determines the timing and magnitude of fiscal inflation. Impulse responses show that the inflation and tax hikes needed to offset a permanent shock to transfers are lowest under nominal interest rate pegs. In this regime, most of the reduction in the real value of government debt comes from open market purchases.     

Stepping on a rake: The role of fiscal policy in the inflation of the 1970s

The inflation of the 1970s in the US is often discussed as if the only type of policy action that could have prevented the inflation were monetary policy actions and the only type of policy errors that might have induced the inflation were monetary policy errors. Yet fiscal policy underwent dramatic shifts in the 1970s and economic theory makes clear that in an environment of uncertainty about future fiscal policy, monetary policy instruments may lose potency or have perverse effects. This paper documents the vagaries of fiscal policy in this period and argues that people at the time must have been uncertain about fiscal policy's future course. It also lays out a theoretical framework for understanding the effects of fiscal uncertainties on monetary policy and shows that fiscal variables have predictive value in dynamic models, even if traditional monetary policy indicators are included in the system.     

Understanding policy in the great recession: Some unpleasant fiscal arithmetic

I use the valuation equation of government debt to understand fiscal and monetary policy in and following the great recession of 2008–2009. I also examine policy alternatives to avoid deflation, and how fiscal pressures might lead to inflation. I conclude that the central bank may be almost powerless to avoid deflation or inflation; that an eventual fiscal inflation can come well before large deficits or monetization are realized, and that it is likely to come with stagnation rather than a boom.     

Identifying fiscal inflation

Fiscal theorists warn about the risk of future inflation as a consequence of fiscal imbalances in the US. Because actual inflation remains historically low and data on inflation expectations do not corroborate such risks, warnings for fiscal inflation are often ignored in policy and academic circles. This paper shows that a canonical NK-DSGE model enables identifying an anticipated component of inflation expectations that is closely related to fiscal policy. Estimation results suggest that fiscal inflation concerns have induced a 1.6%-points increase in long-run inflation since 2001. The model also rationalizes why data on inflation expectations do not reveal such concerns outright.     

MONETARY POLICY,FINANCIAL CONSTRAINTS,AND REDISTRIBUTION

This article examines how financial constraints affect redistribution via monetary policy. We explore a novel mechanism of monetary nonneutrality, which is based on debt limits imposed in nominal terms. Specifically, when debt is constrained by current income, monetary policy can alter the real terms of borrowing. Changes in inflation exert ambiguous effects, depending on the initial debt/wealth position and the willingness to borrow. We show analytically that borrowers can benefit from increased debt limits under lower inflation rates. This novel effect can dominate conventional debt deflation effects. We find that particularly less indebted borrowers as well as potential future borrowers gain and that aggregate welfare can be enhanced under a permanent reduction in inflation.     

Monetary policy,fiscal policy and cross signal jamming

This paper considers the issue of rule versus discretion when the central bank and the government share private information but have different preferences over inflation and output. We demonstrate that if the monetary policy is rule-based, Intuitive Criterion selects the unique separating equilibrium in which the central bank signals a low supply shock by a low interest rate. Interestingly, discretion may be better than the rule for the central bank, contrary to the case of complete information. Also, we examine the effect of information asymmetry on the monetary and fiscal policy mix. We show that cross signal jamming whereby the monetary authority and the fiscal authority successfully jams an unfavorable signal of each other does not occur in equilibrium.     

Multiple Wage Bargaining Systems in the Single European Currency Area

Little attention in the EMU literature has been paid to the interaction between centralbank monetary rules and systems of collective wage bargaining. Analytically andempirically, coordinated wage bargaining systems respond with real wage restraintto non-accommodating monetary policy. Since wage determination is dominated bycollective bargaining in all the EMU member states and wage coordination within themember states has grown since 1980, this is a topic of potential importance. In particular, the replacement of the Bundesbank, directly targeting German inflation, by an ECB targeting European inflation has removed a major institutional support of wage restraint in Germany. The consequences of this for EMU are worked out under two scenarios, that inflation expectations will be generated by ECB monetary policy and that they will reflect German inflation outcomes. Possible institutional developments are discussed including government-union bargains. The Bundesbank has also played a major role in maintaining fiscal rectitude by targeting excess fiscal deficits in Germany: again its replacement by the ECB – targeting (if at all) European rather than German fiscal policy – loosens fiscal constraints. For underlying structural reasons therefore, it is possible that Germany and other EMU countries will move to a period of fiscal activism with wage restraint and low inflation purchased through social contract negotiations.     

Discretionary policy in a monetary union with sovereign debt

This paper examines the interactions between multiple national fiscal policymakers and a single monetary policy maker in response to shocks to government debt in some or all of the countries of a monetary union. We assume that national governments respond to excess debt in an optimal manner, but that they do not have access to a commitment technology. This implies that national fiscal policy gradually reduces debt: the lack of a commitment technology precludes a random walk in steady-state debt, but the need to maintain national competitiveness avoids excessively rapid debt reduction. If the central bank can commit, it adjusts its policies only slightly in response to higher debt, allowing national fiscal policy to undertake most of the adjustment. However, if it cannot commit, then optimal monetary policy involves using interest rates to rapidly reduce debt, with significant welfare costs. We show that in these circumstances the central bank would do better to ignore national fiscal policies in formulating its policy.     

Optimal fiscal and monetary policies in the face of rare disasters

This paper studies optimal fiscal and monetary policies in an economy exposed to large adverse shocks (rare disasters). We contrast optimal policies under commitment and discretion and identify several striking differences between these institutional environments. A government that can commit to its policy plans relies heavily on debt to smooth the adverse effects of large shocks over time. Lack of commitment seriously limits the government's ability to use debt as a shock absorber. Under discretion, an increase in debt leads to an increase in inflation expectations and therefore higher nominal interest rate distortions. Hence, the discretionary government keeps debt in close vicinity of its steady-state level, and the response of taxes, inflation, and interest rates to shocks is much more pronounced under discretion than under commitment. This is particularly relevant for large shocks and when the initial stock of government debt is already high at the time the shock occurs. We also argue that the adverse welfare effects of disasters are larger under discretion than under commitment, but these welfare differentials can be significantly reduced by making the discretionary government inflation averse.     

Financial frictions and optimal stabilization policy in a monetary union

Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem – the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies – does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household.     

Fiscal limits and monetary policy: default vs. inflation

This paper studies the monetary policy trade-off between low inflation and low sovereign risk in the environment where fiscal authorities fail to fully ensure the sustainability of government debt. Building on the Fiscal Theory of Price Level (FTPL) and the Fiscal Theory of Sovereign Risk (FTSR), this paper differs in its baseline assumption about the monetary policy objective, which is neither to rule out defaults regardless of inflation costs (as in FTPL), nor to follow inflation targeting regardless of associated sovereign risk (as in FTSR). Instead, we study the case in which the central bank controls the risky interest rate to minimize the probability of default while ruling out large inflation hikes. We show that this policy regime can mitigate default risks only when the central bank is expected to allow sufficient increases in inflation. When agents believe that the central bank's tolerance toward inflation hikes has increased, equilibrium risk premium goes down, suggesting that information concerning changes in the central bank's preferences over inflation directly impacts default risks.     

Big Brother is also being watched: Measuring fiscal credibility

Fiscal policy is less credible than monetary policy, due to political economy issues. This paper provides an explicit measure of fiscal credibility, based on the anchoring of private expectations onto official targets. It documents how credibility varied among a sample of 27 European countries over 1995–2019. Credibility behaves like a stock of trust that is affected by fiscal policy, past performance, and institutions (fiscal rules and councils). This paper highlights how regular government communication – budgets and fiscal plans – is crucial to anchor expectations and buttress credibility. Last, it shows that credibility is associated with better sovereign financing conditions. Governments should thus strive to maintain their credibility.     

Fiscal policy,macroeconomic performance and industry structure in a small open economy

We analyse how fiscal policy affects both the macroeconomy and the industry structure, using a multi-sector macroeconomic model of the Norwegian economy with an inflation targeting monetary policy. Our simulations show that the magnitude of the government spending and labour tax cut multipliers, whether monetary policy is active or passive, is comparable to what is found in the literature. A novel finding from our simulations is that the industry structure is substantially affected by an expansionary fiscal policy, as value added in the non-traded goods sector increases at the expense of value added in the traded goods sector. Moreover, expansionary fiscal policy reduces the mark-ups in the traded goods sector, while the mark-ups are roughly unchanged in the non-traded goods sector. The contraction of activity in the traded goods sector increases when monetary tightening accompanies the fiscal stimulus. Hence, we find that such a policy mix is likely to produce significant de-industrialization in a small open economy with inflation targeting.     

Fiscal expansion, monetary policy, interest rate risk premia, and wage reactions

We examine the macroeconomic implications of fiscal policy in a small open economy, with emphasis on the interactions between fiscal, monetary and labour market policies. The paper uses the NBNZ-DEMONZ macroeconometric model. Novel features of the model are that it includes an endogenous interest rate risk premium (IRRP), and forward-looking monetary and fiscal policy reaction functions which capture the essence of New Zealand's Reserve Bank and Fiscal Responsibility Acts. The most important empirical result is that the postulated IRRP, proxying financial market mechanisms, can contribute at least as much as the monetary policy reaction function to maintaining price stability. Also of significance are that an income tax cuts package shows more damped real GDP and underlying inflation paths than does an expenditure increases equivalent; and that the inflationary and real sector impacts of a personal income tax cut package depend heavily on how the cut is `shared' between firms and workers. The nature and interdependence of monetary and fiscal policies and labour market conditions are therefore crucial to the macroeconomic outcomes.     

Is fiscal policy always counter- (pro-) cyclical? The role of public debt and fiscal rules

We investigate the reaction of fiscal policy to the business cycle in a panel of 56 developed, emerging and developing economies over 1990–2011. While we strengthen the established finding that fiscal policy is counter-cyclical, additional outcomes emerge from this study. We reveal a non-linear response of fiscal policy to the business cycle, conditional upon the outstanding debt stock. Interestingly, when the public debt-to-GDP ratio goes beyond our endogenously estimated threshold of 87%, fiscal policy turns pro-cyclical. To tackle this effect, we explore the role of fiscal rules (FR). We unveil heterogeneous impacts among FR, as only some of them may mitigate fiscal policy procyclicality in high-debt contexts.     

Monetary and fiscal policy interactions in a post Keynesian open-economy model

Using a post Keynesian model, this study aims to analyze the stabilizing role of fiscal and monetary policies in an open economy with a managed exchange rate regime. The real exchange rate is modeled as an endogenous variable and inflation explained using the conflicting claims approach. The dynamic properties of macroeconomic equilibrium are evaluated in different regimes of fiscal and monetary policies. The main result of this study suggests that the preferred policy regime is the one in which economic authorities are complementary and fiscal policy plays an explicitly active role. In this regime, the fiscal policy must commit to the target for the rate of capacity utilization and the monetary authority must commit to the inflation target.     

Optimal monetary and fiscal policies in a search theoretic model of monetary exchange

Search models of monetary exchange commonly assume that terms of trade in anonymous markets are determined via Nash bargaining, which generally causes monetary equilibrium to be inefficient. Bargaining frictions add to the classical intertemporal distortion present in most monetary models, whereby agents work today to obtain cash that can be used only in future transactions. In this paper, we study the properties of optimal fiscal and monetary policy within the framework of Lagos and Wright (2005). We show that fiscal policy can be implemented to alleviate underproduction while money is still essential. If lump sum monetary transfers are available, a production subsidy can restore the efficiency of monetary equilibria. The Friedman rule belongs to the optimal policy set, but higher inflation rates are also possible. When lump-sum monetary transfers are not available, equilibrium allocations are generally not first-best. Nevertheless, fiscal policy still results in substantial welfare gains. Money can be extracted from circulation via a sales tax on decentralized market activities, and the Friedman rule is only optimal if the buyer has relatively low bargaining power.     

Monetary and Fiscal Policy Interactions in the Euro Area

The problem of monetary and fiscal policy interactions is an important issue for the euro area, since the individual member states of the EMU are responsible for their fiscal policies but monetary policy is pursued by a single monetary authority, the ECB. This paper is concerned with empirical evidence on monetary and fiscal policy interactions in the euro area. We first explore fiscal regimes with a VAR model and find empirical evidence that a non-Ricardian fiscal policy has been pursued in both France and Germany. As an example, we then study how one member state of the EMU, namely, Italy, is responding to the common monetary policy with its fiscal policy and find that Italian fiscal policy seemed to be counteractive to the common monetary policy between 1979 and 1998. In order to study monetary and fiscal policy interactions in a more general way, we explore time-varying interactions by estimating a State-Space model with Markov-switching for some Euro-area countries. There appear to be some regime changes in monetary and fiscal policy interactions in France and Germany, but the interactions between the two policies are not strong. Moreover, the two policies have not been accommodative but counteractive to each other. Finally we explore forward-looking behavior in policy interactions and find that expectations do not seem to have played an important role in the policy designs.     

Deficit sustainability and inflation in EMU: An analysis from the Fiscal Theory of the Price Level

Price determination theory typically focuses on the role of monetary policy, while the role of fiscal policy is usually neglected. From a different point of view, the Fiscal Theory of the Price Level takes into account monetary and fiscal policy interactions and assumes that fiscal policy may determine the price level, even if monetary authorities pursue an inflation targeting strategy. In this paper we try to test empirically whether the time path of the government budget in EMU countries would have affected price level determination. Our results point to the sustainability of fiscal policy in all the EMU countries but Finland, although no firm conclusions can be drawn about the prevalence of either monetary or fiscal dominance.     

Term structure and forward guidance as instruments of monetary policy

This paper studies a simple monetary model with a Ricardian fiscal policy in which equilibria are indeterminate if monetary policy consists solely of a rule for fixing the short-term interest rate. We introduce explicitly into the model the agents’ expectations of inflation which create the indeterminacy and show that there are two types of policies—a term structure rule or a forward guidance rule for the short rate—which lead to determinacy. The first consists in fixing the interest rates on a family of bonds of different maturities as function of realized inflation; the second consists in fixing the short-term interest rate and the expected values of the short-term interest rate for a sequence of periods into the future as a function of realized inflation. If the monetary authority chooses an inflation process that satisfies conditions derived in the paper and applies one of these rules, it anchors agents’ expectations to this process, in the sense that it is the unique inflation process compatible with equilibrium when the interest rates or expected future values of the short rate are those specified by the term structure or forward guidance rule.