Download Simple Monetary Rules Under Fiscal Dominance

WP/07/271
Simple Monetary Rules Under Fiscal
Dominance
Michael Kumhof, Ricardo Nunes, and
Irina Yakadina
© 2007 International Monetary Fund
WP/07/271
IMF Working Paper
Research Department and IMF Institute
Simple Monetary Rules Under Fiscal Dominance
Prepared by Michael Kumhof, Ricardo Nunes, and Irina Yakadina1
Authorized for distribution by Gian-Maria Milesi-Ferretti and Enrica Detragiache
December 2007
Abstract
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.
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.
JEL Classification Numbers: E61, E62
Keywords: Optimal simple policy rules, fiscal dominance
Author’s E-Mail Address: [email protected]; [email protected]; [email protected]
1
Michael Kumhof is a senior economist in the Research Department; Ricardo Nunes is from the Federal Reserve
Board; and Irina Yakadina is an economist in the IMF Institute.
-2-
Contents
Page
I.
Introduction..................................................................................................................... 3
II.
The Model....................................................................................................................... 6
III.
Monetary Policy in a Ricardian World ........................................................................... 8
IV.
Monetary Policy under Fiscal Dominance.................................................................... 11
A. Government Spending in the Interest Rate Rule..................................................... 11
B. Government Liabilities in the Interest Rate Rule ................................................... 12
V.
Conclusion .................................................................................................................... 14
References ................................................................................................................................. 17
Figures
1
Ricardian Fiscal Policy and the Taylor Rule ................................................................ 19
2a
Productivity Shock under Ricardian Fiscal Policy ....................................................... 20
2b
Government Spending Shock under Ricardian Fiscal Policy ....................................... 21
3
Fiscal Dominance and Interest Rate Feedback to Government Spending.................... 22
4
Fiscal Dominance and Interest Rate Feedback to Government Liabilities................... 23
5a
Productivity Shock under Fiscal Dominance................................................................ 24
5b
Government Spending Shock under Fiscal Dominance ............................................... 25
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Tax Revenue
20
0
−0.005
−0.01
10
Real Interest Rate
0
20
0
0
10
Debt to GDP Ratio
20
0
10
0 #
E @ )
0
20
&
0
10
Output
20
0
10
Consumption
20
−0.2
2
−0.02
20
0
4
−0.01
10
Labor
0.4
0.2
0
−0.2
0.5
0
0
0.4
0.2
0
−0.2
0.2
−0.02
−0.04
0
3
0
−1
Real Wage
Government Spending
0
10
&
20
#
>
0
0
10
F
20
C
D
9
7 #
11.7
23
0.9
.0
5
0
05
−−00
..2481
−0
−0
1
.2
.2
8
1
0.
Coefficient on Government Spending
−1
−0.41
Coefficient on Government Spending
0
2
1.7
3
1.9
1.72
0.05
1
−0.4
−2
0 #
Coefficient on Inflation
E 0
C
1
−3
1
" $
"
>
0
Coefficient on Inflation
1
3
M
@ )
&
C
D
−1
7 #
.5
2.224
.2
5
C
Coefficient on Liabilities
1.
0
54
1
−3
" $
"
2.5
;E 0
3
4
0 #
1
5
2.4
2.
Coefficient on Inflation
4
82
5
1
−3
1.5
1.
.2
−0
25
0.
422−
0.3.
−−0
.32
−0 .42
−0
2.2
2
1.8
2
−0.4
.32
−0
5
0
82
1.
−0.2
.3.422
−−00
−0
Coefficient on Liabilities
9
−1
>
0
1.8
2
4
2.5
2.2
Coefficient on Inflation
1
3
M
@ )
9
;
Productivity
1
2
Real Wage
1
0.5
0
−0.5
0
1
0
Government Spending
0
10
20
Nominal Interest Rate
1
0.5
−1
0
1
10
Tax Rate
20
0
10
Inflation
20
0
−0.2
−0.4
−0.6
−0.8
0
10
Real Interest Rate
20
1
0.5
0
0
10
0 #
20
' E F
−1
1
0
−1
−2
−3
1.5
1
0.5
0
#
10
Labor
20
0
10
Output
20
0
10
Consumption
20
0
−1
0
0
0
−2
0
10
Tax Revenue
20
1
0.5
0
0
10
Debt to GDP Ratio
20
1.5
1
0.5
0
0
)
10
&
20
#
0
0
C
10
20
'
Productivity
1
Government Spending
0
−1
0
10
20
Nominal Interest Rate
0
−0.5
3
3
2
2
1
1
0
0
1
10
Tax Rate
0
20
0
10
Inflation
20
0.5
10
Real Interest Rate
20
0
−0.5
0
20
2
2
1
0
0
0
10
Tax Revenue
4
0
10
Debt to GDP Ratio
0
20
−1
0
10
0 #
20
' E @ )
−4
20
0
10
Output
20
0
10
Consumption
20
2
−2
−1.5
10
Labor
1
6
1
0
−1
0
2
0
−1
0
Real Wage
1
0
0
10
&
&
20
#
0
0
C
10
20