Simple Monetary Rules Under Fiscal Dominance

27 Pages Posted: 21 Dec 2007

See all articles by Michael Kumhof

Michael Kumhof

CEPR

Irina V. Yakadina

International Monetary Fund (IMF)

Ricardo Cavaco Nunes

Federal Reserve Banks - Federal Reserve Bank of Boston

Multiple version iconThere are 2 versions of this paper

Date Written: December 2007

Abstract

Is aggressive monetary policy response to inflation feasible in countries that suffer from fiscal dominance? We find that if nominal interest rates are allowed to respond to government debt, even aggressive rules that satisfy the Taylor principle can produce unique equilibria. However, resulting inflation is extremely volatile and zero lower bound on nominal interest rates is frequently violated. Within the set of feasible rules the optimal response to inflation is highly negative, and more aggressive inflation fighting is inferior from a welfare point of view. The welfare gain from responding to fiscal variables is minimal compared to the gain from eliminating fiscal dominance.

Keywords: Monetary policy, Inflation, Interest rates, Debt, Government expenditures

Suggested Citation

Kumhof, Michael and Yakadina, Irina V. and Nunes, Ricardo Cavaco, Simple Monetary Rules Under Fiscal Dominance (December 2007). IMF Working Paper No. 07/271, Available at SSRN: https://ssrn.com/abstract=1075887

Michael Kumhof (Contact Author)

CEPR ( email )

London
United Kingdom

Irina V. Yakadina

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Ricardo Cavaco Nunes

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

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