Simple Monetary Rules under Fiscal Dominance

37 Pages Posted: 31 Oct 2008

See all articles by Michael Kumhof

Michael Kumhof

CEPR

Ricardo Cavaco Nunes

Federal Reserve Banks - Federal Reserve Bank of Boston

Irina V. Yakadina

International Monetary Fund (IMF)

Multiple version iconThere are 2 versions of this paper

Date Written: July 30, 2008

Abstract

This paper asks whether an aggressive monetary policy response to inflation is feasible in countries that suffer from fiscal dominance, as long as monetary policy also responds to fiscal variables. 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. But following such rules results in extremely volatile inflation. This leads to very frequent violations of the zero lower bound on nominal interest rates that make such rules infeasible. Even 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: Optimal simple policy rules, fiscal dominance

JEL Classification: E61, E62

Suggested Citation

Kumhof, Michael and Nunes, Ricardo Cavaco and Yakadina, Irina V., Simple Monetary Rules under Fiscal Dominance (July 30, 2008). Available at SSRN: https://ssrn.com/abstract=1292342 or http://dx.doi.org/10.2139/ssrn.1292342

Michael Kumhof

CEPR ( email )

London
United Kingdom

Ricardo Cavaco Nunes (Contact Author)

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

Irina V. Yakadina

International Monetary Fund (IMF) ( email )

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

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