Anchors Away: How Fiscal Policy Can Undermine 'Good' Monetary Policy

Abstract:     
Slow moving demographics are aging populations around the world and pushing many countries into an extended period of heightened fiscal stress. In some countries, taxes alone cannot or likely will not fully fund projected pension and health care expenditures. If economic agents place sufficient probability on the economy hitting its “fiscal limit” at some point in the future - after which further tax revenues are not forthcoming - it may no longer be possible for “good” monetary policy behavior to control inflation or anchor inflation expectations. In the period leading up to the fiscal limit, the more aggressively that monetary policy leans against inflationary winds, the more expected inflation becomes unhinged from the inflation target. Problems confrontingmonetary policy are exacerbated when policy institutions leave fiscal objectives and targets unspecified and, therefore, fiscal expectations unanchored.

Number of Pages in PDF File: 34

working papers series