A Fiscal Theory of Money and Banking
47 Pages Posted: 30 Nov 2021
Abstract
We introduce banks to the fiscal theory of price level to study the effectiveness of open market operations in correcting the distortions caused by an improper taxrate. A rise in the tax rate increases the real purchasing power of payment liquidity for short-term consumption, but reduces firms’ incentive to take loans for longterm investment. An excessively low tax rate leads to an over-investment problem, which can be rectified by a combination of reverse repo operations and a positive reserve requirement. The optimal reverse repo rate is a function of the “fiscal gap”, that is, the difference between the optimal tax rate and the actual tax rate. By contrast, an excessively high tax rate leads to an under-investment problem. Open market operations are ineffective in this case as the zero lower bound of interest rates prevents the central bank from injecting additional credit to the economy.
Keywords: Liquidity Shocks, Fiscal Policy, monetary policy, fiscal theory of price level, Monetization of Fiscal Debt
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