Simple Monetary Rules Under Fiscal Dominance

Author/Editor:

Michael Kumhof ; Ricardo C Nunes ; Irina Yakadina

Publication Date:

December 1, 2007

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

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.

Series:

Working Paper No. 2007/271

Subject:

Expenditure Fiscal policy Inflation Real interest rates Zero lower bound

English

Publication Date:

December 1, 2007

ISBN/ISSN:

9781451868340/1018-5941

Stock No:

WPIEA2007271

Pages:

25

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