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.     

Monetary policy under a fiscal theory of sovereign default

This paper examines equilibrium determination under different monetary policy regimes when the government might default on its debt. We apply a cash-in-advance model where the government does not have access to non-distortionary taxation and does not account for initial outstanding debt when it sets the income tax rate. Solvency is then not guaranteed and sovereign default can affect the return on public debt. If the central bank sets the interest rate in a conventional way, the equilibrium allocation cannot be determined. If, instead, money supply is controlled, the equilibrium allocation can uniquely be determined.     

Inflation and Exchange Rate Targeting Challenges Under Fiscal Dominance

Countries have significantly increased their public-sector borrowing since the Global Financial Crisis. As a consequence, monetary authorities may face pressure to deviate from their policy targets in ways designed to ease the debt burden. In view of this consideration, we test for greater fiscal dominance over 2000-2017 under Inflation Targeting (IT) and non-IT regimes. We find that evidence of fiscal dominance varies across countries and debt configurations. Higher ratios of public debt-to-GDP may appear associated with lower policy interest rates in advanced economies. However, a declining natural rate of interest largely explains the pattern of lower rates and higher debt in these countries. The most robust evidence of fiscal dominance lies among emerging markets under non-IT regimes, composed mostly of exchange rate targeters. For these countries, policy interest rates are non-linearly associated with public debt levels, depending on both the level of hard-currency public debt-to-GDP and the currency composition of public debt. We also show that emerging market economies with greater exchange rate volatility, inflation volatility, and underlying commodity exposure exhibit stronger associations between public debt and policy interest rates.     

Fiscal Rules,Interest Payments on Debt,and the Irrelevance of the Taylor Principle

We show that in New Keynesian models with non‐neutral government debt, the Taylor principle ceases to be relevant for equilibrium determinacy if the government follows a fiscal rule of levying taxes in proportion to its interest payments on existing debt. This is in contrast with previous studies, which typically have assumed that taxes respond to the level of debt, and have found either a confirmation or reversal of the Taylor principle depending on the feedback from debt to taxes. We find, instead, that the equilibrium effect of the interest rate on debt is crucial for determinacy. If, as in our model, taxes are raised in response to debt interest payments, the range of indeterminacy monotonically decreases with the fiscal feedback parameter. When interest payments are completely tax‐financed, indeterminacy is ruled out without any restrictions on monetary policy.     

Optimal Monetary Policy, Taxes, and Public Debt in an Intertemporal Equilibrium

This article is devoted to a study of the optimal monetary and fiscal policies within the framework of an overlapping generations model with cash-in-advance constraints. We first characterize the intertemporal equilibrium. Then we show how to decentralize the optimal growth path using available policy instruments (i.e., labor income and capital taxes, public debt, money supply). Between the four instruments: wages and capital taxes, debt and monetary policy, one is redundant among the three last which implies that the Friedman Rule is only a special case.     

Equilibrium Determinacy under Monetary and Fiscal Policies in an Overlapping Generations Model

This paper studies the issue of equilibrium determinacy under monetary and fiscal policy feedback rules in an optimizing general equilibrium model with overlapping generations and flexible prices. It is shown that equilibria may be determinate also when monetary and fiscal policies are both 'passive'. In particular, under passive monetary rules, equilibrium uniqueness is more likely to be verified when fiscal policies are less committed to public debt stabilization.     

THE BEHAVIOR OF U.S. PUBLIC DEBT AND DEFICITS DURING THE GLOBAL FINANCIAL CRISIS

In this paper we test the sustainability of U.S. public debt for the period 1916–2012 by analyzing how the primary surplus to gross domestic product (GDP) responds to changes in the debt to GDP ratio in a time‐varying parameter model. Further, we determine the stationarity property of the debt/GDP ratio while accommodating possible breaks in the data caused by wars and economic crisis under both the null and alternative hypotheses of an endogenous unit root test. The results show that the U.S. public debt was sustainable until 2005 when the primary surplus to GDP reacted negatively to the debt/income ratio. This is further exacerbated during the global financial crisis when primary surpluses continued to fall with increased debt, thus jeopardizing the sustainability of fiscal policy. While the stationarity test shows that the U.S. fiscal debt/GDP ratio is sustainable, it fails to highlight the risk that its debt policy has been becoming unsustainable in recent years. (JEL H62, E62, C2)     

CONTROLLING INFLATION WITH TIMID MONETARY–FISCAL REGIME CHANGES

Can monetary policy control inflation when both monetary and fiscal policies change over time? When monetary policy is active, a long-run fiscal principle entails flexibility in fiscal policy that preserves determinacy even when deviating from passive fiscal, substantially for brief periods or timidly for prolonged periods. In order to guarantee a unique equilibrium, monetary and fiscal policies must coordinate not only within but also across regimes, and not simply on being active or passive, but also on their extent. The amplitude of deviations from the active monetary/passive fiscal benchmark determines whether a regime is Ricardian: Timid deviations do not imply wealth effects.     

Policy Rules and Monetarist Arithmetic

This note demonstrates the existence of an important equilibrium path overlooked in the literature on monetarist arithmetic. Pleasant monetarist arithmetic is possible when the interest‐elasticity of money demand exceeds unity. In this case, tight money may lead to a transitory increase in seigniorage, the retirement of government debt, and lower inflation in both the short run and the long run. The set of equilibrium paths is sensitive, however, to the form of the policy rule. Pleasant monetarist arithmetic is not an equilibrium if the policy rule fixes the share of the fiscal deficit financed by seigniorage. Both pleasant monetarist arithmetic and the tight‐money paradox are equilibrium paths when the government's commitment to low money growth is conditional on inflation remaining below its previous level.     

Debt Policy Rules in an Open Economy

In a small open economy model of endogenous growth with public capital accumulation, we examine the effects of a debt policy rule under which the government must reduce its debt–GDP ratio if it exceeds the criterion level. To sustain public debt at a finite level, the government should adjust public spending rather than the income tax rate. The long‐run debt–GDP ratio should be kept sufficiently low to avoid equilibrium indeterminacy. Under sustainability and determinacy, a tighter (looser) debt rule brings welfare gains when the world interest rate is relatively high (low).     

公共资本投资、内生经济增长与合理政府债务规模*

本文基于一个具有内生增长机制的三部门世代交叠模型,讨论了政府举债为公共投资进行融资时经济的长期均衡;同时,通过数值模拟方法考察了我国的均衡政府债务规模及其影响因素。结果表明：在特定条件下,经济系统存在一个正的均衡政府债务-产出比重,该债务比重水平明显受到公共投资—产出比重、公共投资的债务融资比重、民间资本产出弹性等参数的影响。但是,均衡政府债务比重并不是无限上升的,当上述参数超过特定临界值时,经济系统无法达到均衡,政府债务-产出之比将持续上升,财政将不可持续。另外,当民间资本产出弹性较低时,较高的均衡政府债务比重可能导致经济运行动态无效率。数值模拟结果还显示,基于不同的假设情形,我国的均衡政府债务-产出比重均在不同程度上高于当前实际的政府债务规模,这为我国在未来期间实施扩张性财政政策提供了有利的依据。     

A simple model for study of the determination of the price level and the interaction of monetary and fiscal policy

Summary A representative-agent model with money holdings motivated by transactions costs, a fiscal authority that taxes and issues debt, no production, and a convenient functional form for agents' utility is presented. The model can be solved analytically, and illustrates the dependence of price determination on fiscal policy, the possibility of indeterminacy, even stochastic explosion, of the price level in the face of a monetary policy that holdsM fixed, and the possibility of a unique, stable price level in the face of a monetary policy that simply pegs the nominal interest rate at an arbitrary level.In a rational expectations, market-clearing equilibrium model with a costlessly-produced fiat money that is useful in transactions, the following things are true under broad assumptions.- A monetary policy that fixes the money stock may (depending on the transactions technology) be consistent with indeterminacy of the price level—indeed with stochastically fluctuating, explosive inflation.- A monetary policy that fixes the nominal interest rate, even if it holds the interest rate constant regardless of the observed rate of inflation or money growth rate, may deliver a uniquely determined price level.- The existence and uniqueness of the equilibrium price level cannot be determined from knowledge of monetary policy alone; fiscal policy plays an equally important role. Special case models with interest-bearing debt and no money are possible, just as are special cases with money and no interest-bearing debt. In each the price level may be uniquely determined.Determinacy of the price level under any policy depends on the public's beliefs about what the policy authority would do under conditions that are never observed in equilibrium.These points are not new. Eric Leeper [1991] has made most of them within a single coherent model. Woodford [1993], in a representative agent cash-in-advance model, has displayed the possibility of indeterminacy with a fixed quantity of money and the possibility of uniqueness with an interest-rate pegging policy. Aiyagari and Gertler [1985] use an overlapping generations model to make many of the points made in this paper, without discussing the possibility of stochastic sunspot equilibria. Sargent and Wallace [1981] and Obstfeld [1983] have also discussed related issues.This paper improves on Leeper by moving beyond his analysis of local linear approximations to the full model solution, as is essential if explosive sunspot equilibria are to be distinguished from explosive solutions to the Euler equations that can be ruled out as equilibria. It improves on the other cited work by pulling together into the context of one fairly transparent model discussion of phenomena previously discussed in isolation in very different models.We study a representative agent model in which there is no production or real savings, but transactions costs generate a demand for money. The government costlessly provides fiat money balances, imposes lump-sum taxes, and issues debt, but has no other role in the economy. We make restrictive assumptions about the form of the utility function and the form of a transactions cost term in the budget constraint.The model could be extended to include production, capital accumulation, non-neutral taxation, productive government expenditure, and a more general utility function without affecting the conclusions discussed in this paper. Indeed the model I informally matched to data in an earlier paper [1988] makes some such extensions. While such an extended model is more realistic, it is harder to solve. The version in my earlier paper [1988] was solved numerically and simulated. The bare-bones model of this paper allows an explicit analytic solution that may make its results easier to understand.This paper improved following comments from participants at seminars at Yale and the Atlanta Federal Reserve Bank. Eric Leeper and James Robinson were particularly helpful. Comments from Michael Woodford led to important corrections and clarifications.     

Investigating heterogeneity in European fiscal behaviours

The aim of this paper is to analyse the heterogeneity in fiscal behaviours in the euro zone. The fiscal behaviours are analysed according to a new specification in which the cyclically adjusted primary balance reacts to the change in the output gap, the public debt ratio, the inflation rate and the interest rate. Our study covers 12 countries in the euro zone during 1999–2010 using annual data from the AMECO database. We use the quantile regression methodology to test the fiscal rule. Our findings show the persistence in fiscal behaviour and counter‐cyclical fiscal policy. The results also show that fiscal responses differ according to the chosen quantile. In particular, a high fiscal indicator is associated with a debt‐stabilisation motive and concern about inflation. A shock analysis indicates how the fiscal dispersion could be changed according to the nature of the shock. The results of this paper are useful for understanding fiscal coordination and for improving the European fiscal framework.     

Interactions between Monetary and Fiscal Policy Rules

The Fiscal Stability Pact for EMU implies that constraints on fiscal policy facilitate inflation control. In this paper we identify two stable policy regimes. When monetary policy seeks to raise real interest rates in response to excess inflation, a self-stabilising fiscal policy is required to ensure model stability. A fiscal policy which does not, by itself, ensure fiscal solvency constrains monetary policy to be relatively 'passive'. However, in simulations we conclude that the central bank does not need to seek, on this account, the degree of debt stabilisation that appears to be implied by the fiscal stability pact.     

The Crisis of America’s Cities

This paper aims to show how state intervention within the European Monetary Union can have positive effects not only on growth but also on public balances and debt. The relation between centralized monetary policy and decentralized fiscal policy partly solves the lack of coordination between the two. Each time a fiscal expansion in an EU country is not accompanied by a Central Bank interest rate increase, the expansionary effect of public spending, initially financed through the emission of public bonds, will be reinforced by endogenous money creation due to the increase in growth. The final result, if growth exceeds the rate of interest, is not only an increase in equilibrium income, but also a reduction in debt.     

Monetary policy and transmission mechanism in Brazil: an empirical model

We propose an econometric model for the transmission mechanism in Brazil after the inflation target regime (IT) implementation. We follow the statistical approach based on the LSE methodology by means of the Spanos (J Econom 44:87–105, 1990) categorization. Our proposed model includes the ratios of the debt and primary surplus to the GDP representing the government fiscal effort. We identify two long run relationships that produce new information on how to evaluate the real interest rate and the nominal interest rate links, respectively, with the output gap and the nominal inflation derived from the IS and the interest rule theoretical models. Such specification explores the role played by fiscal variables in monetary transmission; considering the government fiscal effort, a relevant issue for Brazil. We were also able to identify a third long run relationship that might help to uncover how output gap is related not only with nominal variables but also with the debt to the GDP ratio.     

Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers

The paper examines simple monetary and fiscal policy rules consistent with determinate equilibrium dynamics in the absence of Ricardian equivalence. Under this assumption, government debt turns into a relevant state variable which needs to be accounted for in the analysis of equilibrium dynamics. The key analytical finding is that without explicit reference to the level of government debt it is not possible to infer how strongly the monetary and fiscal instruments should be used to ensure determinate equilibrium dynamics. Specifically, we identify bifurcations associated with threshold values of steady-state debt, leading to qualitative changes in the local determinacy requirements.     

Optimal fiscal and monetary policy with sticky wages and sticky prices

We determine the optimal degree of price inflation volatility when nominal wages are sticky and the government uses state-contingent inflation to finance government spending. We address this question in a well-understood Ramsey model of fiscal and monetary policy, in which the benevolent planner has access to labor income taxes, nominally risk-free debt, and money creation. Our main result is that sticky wages alone make price stability optimal in the face of shocks to the government budget, to a degree quantitatively similar as sticky prices alone. Key for our results is an equilibrium restriction between nominal price inflation and nominal wage inflation that holds trivially in a Ramsey model featuring only sticky prices. Our results thus show that when nominal wages are sticky, setting real wages as close as possible to their efficient path is a more important goal of optimal monetary policy than is financing innovations in the government budget via state-contingent inflation. A second important result is that the nominal interest rate can be used to indirectly tax the rents of monopolistic labor suppliers. Taken together, our results uncover features of Ramsey fiscal and monetary policy in the presence of a type of labor market imperfection that is widely-believed to be important.     

ENDOGENOUS TIME PREFERENCE,INTEREST‐RATE RULES,AND INDETERMINACY*

This paper extends the Benhabib et al. flexible‐price, money‐in‐the‐utility‐function model by considering endogenous time preference and re‐examines equilibrium indeterminacy in response to alternative interest‐rate rules. We show that either an active or a passive interest‐rate feedback rule can generate local indeterminacy even if consumption and real money balances are Edgeworth independent. This result is in sharp contrast to that in the related literature. We also find that in the presence of endogenous time preference, local indeterminacy may occur regardless of whether the monetary policy is based on the interest‐rate feedback rule or money growth‐rate targeting.