Dynamic Fiscal Limits and Monetary-Fiscal Policy Interactions

43 Pages Posted: 29 Apr 2019

See all articles by Niccolò Battistini

Niccolò Battistini

Rutgers, The State University of New Jersey - Rutgers University, Newark

Giovanni Callegari

International Monetary Fund

Luca Zavalloni

University of Bologna; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research; University of Warwick

Date Written: April 17, 2019

Abstract

This paper analyzes the impact of monetary policy on public debt sustainability through the lens of a general equilibrium model with fiscal limits. We find that the mere possibility of a binding ZLB may have detrimental effects on debt sustainability, as a kink in the Laffer curve induces a dead-weight loss in the present discounted value of future primary surpluses. Moreover, debt sustainability improves with monetary policy activeness, that is, with the elasticity of the interest rate to changes in inflation and the output gap. On this basis, we assess the trade-off between economic stabilization and debt sustainability depending on the monetary policy environment. In normal times, large public spending shocks may engender perverse debt dynamics and cause economic contractions. At the ZLB, a muted tradeoff between stabilization and sustainability instead expands the fiscal margin, especially if coupled with a commitment to a more active monetary policy during normal times.

Keywords: fiscal sustainability, monetary policy, ZLB

JEL Classification: E52, E61, E63

Suggested Citation

Battistini, Niccolò and Callegari, Giovanni and Zavalloni, Luca, Dynamic Fiscal Limits and Monetary-Fiscal Policy Interactions (April 17, 2019). ECB Working Paper No. 2268. Available at SSRN: https://ssrn.com/abstract=3374165

Niccolò Battistini (Contact Author)

Rutgers, The State University of New Jersey - Rutgers University, Newark

180 University Avenue
Newark, NJ 07102
United States

Giovanni Callegari

International Monetary Fund ( email )

700 19th Street, NW
Washington, DC 20431
United States

Luca Zavalloni

University of Bologna ( email )

Piazza Scaravilli 2
Bologna, 40100
Italy

Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research ( email )

Via Roentgen 1
Milan, 20136
Italy

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom

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