Monetary Instrument Problem Revisited: The Role of Fiscal Policy

Abstract

The monetary instrument problem is examined in an endowment economy model with various stochastic disturbances, with minimizing the variance of inflation as the policy objective. Following current developments in the theory of fiscal determination of the price level, for different monetary policies, active or passive fiscal policy is specified to guarantee a unique equilibrium. The responses of inflation to various structural disturbances in the constant money growth rate-passive fiscal (the active monetary-passive fiscal regime, or the conventional regime where Ricardian equivalence and Quantity Theory of Money hold) and the constant interest rate-active fiscal regime (the passive monetary-active fiscal regime, or the regime where fiscal policy determines the price level) are explained based on monetary and fiscal policies' role in financing government deficit changes and satisfying the government budget constraint in each regime, which is different from the explanations of past research following Poole. One of the interesting findings is that an increase in the steady state real value of nominal government debts (bonds) reduces the variance of inflation in the passive monetary-active fiscal regime.

Keywords: Monetary instrument problem, variance of inflation, fiscal policy, nominal government debt, fiscal determination of the price level

JEL Classification: E63, E52, E31