Simple Monetary Rules under Fiscal Dominance

Authors


  • The authors thank Daniel Beltran, Jordi Galí, Michel Juillard, Eric Leeper and seminar participants at the Bank of Canada, the Federal Reserve Board, the International Monetary Fund (IMF), the Society of Government Economists, and Universitat Pompeu Fabra for helpful comments. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the IMF, the IMF Executive Board, IMF management, the Board of Governors of the Federal Reserve System, or any other person associated with the Federal Reserve System.

Abstract

This paper asks whether interest rate rules that respond aggressively to inflation, following the Taylor principle, are feasible in countries that suffer from fiscal dominance. We find that if interest rates are allowed to also respond to government debt, they can produce unique equilibria. But such equilibria are associated with extremely volatile inflation. The resulting frequent violations of the zero lower bound make such rules infeasible. Even within the set of feasible rules the welfare optimizing response to inflation is highly negative. The welfare gain from responding to government debt is minimal compared to the gain from eliminating fiscal dominance.

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