Rosso, Biagio and Gatto, Matteo (2024): Dynamics and Optimal Monetary-Fiscal Policy in Fiscally Dominant Economies with Occasionally Inflexible Monetary Authorities.
![]() |
PDF
MPRA_paper_125094.pdf Download (2MB) |
Abstract
What are key macroeconomic consequences of an occasionally binding debt-control policies in economies operating under Fiscal Dominance? From a kindred theoretical perspective, what happens when relaxing the "Sargent" assumption of a perfectly flexible monetary authority to occasionally inflexibility in the form of limits to the quantity of debt or money-growth at which the authority is willing to operate? Finally, how does this matter for optimal fiscal-monetary rules and interactions in such contexts, in particular for the desirability of inflation-targeting? The organising framework we propose, unifying MD and FD with and without occasional inflexibility is (i) a DSGE sticky-price model admitting both MD and FD as alternative solutions to indeterminacy of the equilibrium inflation path, and (ii) extended to account for occasionally binding upper boundaries to quantity of debt through which passive monetary authorities is willing to assist the dominant fiscal side (occasional policy inflexibility). Drawing on the OccBin approach in the sequence space for the analysis of DSGE models featuring non-linearities arising from endogenous regime switching, including occasionally binding constraints, we study transitional dynamics in response to shocks, and optimal monetary-fiscal policy, across unconstrained MD, FD, and FD with occasional policy inflexibility. We provide two ways of integrating this occasionally binding policy-side or supply-side constraint: an overdetermined system with temporary disequilibria or policy-induced shortages, solved for through Least Squares, and one in which the Monetary Authority endogenously deviates from its standard behaviour to enforce the inflexible policy. Subsequently, an "optimal policy" exercise -- via optimal simple rules -- is conducted seeking to identify the monetary-fiscal policy pairs that minimise a standard quadratic loss function. Based on the analysis of impulse responses and the optimal policy rules exercise, we highlight a number of new results, relevant to both theory and policy applications, on FD economies emerging from accounting for occasionally inflexibility in the form of debt ceilings. In order: dynamics display emergent properties, in the form of endogenous higher macroeconomic volatility and a recessionary-deflationary cycle; macroeconomic stabilisation is more difficult to achieve under strong inflation targeting than under perfectly flexible passive policy; more dovish monetary rules outperform hawkish ones (targeting inflation as strong as feasible under the passive monetary policy requirements); gradualism in policy reform could lead to the emergence of policy traps; more systematic fiscal policy intervention could reinstate (relative) optimality of stronger inflation targeting.
Item Type: | MPRA Paper |
---|---|
Original Title: | Dynamics and Optimal Monetary-Fiscal Policy in Fiscally Dominant Economies with Occasionally Inflexible Monetary Authorities |
Language: | English |
Keywords: | fiscal dominance; optimal monetary-fiscal policy; occasionally binding constraints; debt ceiling; endogenous regime switching; NK models; shortages; shortages as endogenous regime switches; inflation path indeterminacy; |
Subjects: | C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level ; Inflation ; Deflation E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E63 - Comparative or Joint Analysis of Fiscal and Monetary Policy ; Stabilization ; Treasury Policy |
Item ID: | 125094 |
Depositing User: | Mr Biagio Rosso |
Date Deposited: | 03 Jul 2025 13:59 |
Last Modified: | 03 Jul 2025 13:59 |
References: | Ascari, G., Florio, A., and Gobbi, A. (2023). Price Level Targeting under Fiscal Dominance, Journal of Money and Finance, 137. Bianchi, F. (2013). Regime switches, Agents’ Beliefs, and Post-World War II U.S. Macroeconomic Dynamics, Review of Economic Studies, 80: 463–490. Buiter, Willem H. (1999). The fallacy of the fiscal theory of the price level. Working Paper 28 7302, National Bureau of Economic Research. Buiter (2002).The fiscal theory of the price level: a critique. Economic Journal 112:459–30 480. Buiter (2017).The Fallacy of the Fiscal Theory of the Price Level - Once More} . CEPR 32 Discussion Paper. Cochrane (2005). Money as Stock. Journal of Monetary Economics 52:501–528. Cochrane, J.H. (2011). Determinacy and Identification with Taylor Rules, Journal of Political Economy, 319(3): 565-615. Cochrane, J.H. (2021). The Fiscal Theory of the Price Level: An Introduction and Overview. Cochrane, J.H. (2022). Expectations and the Neutrality of Interest Rates, Conference on "Foundations of Monetary Policy", September 2022, FED Minneapolis. Cochrane, J.H. (2023). The Fiscal Theory of the Price Level. Princeton University Press. Commons Library Research Briefing. (2024).The UK's Fiscal Targets (by Matthew Keep)}. UK Parliament, House of Commons. Eichengreen, B., Hausmann, R., and Panizza, U. (2003). The Pain of Original Sin. Working Paper, Berkeley Econometrics Laboratory. Guerrieri,L. and M. Iacoviello. (2015). OccBin:A toolkit for solving dynamic models with occasionally binding constraints easily, Journal of Monetary Economics, 70: 22-38. Holden, T., Paetz, M., (2012). Efficient simulation of dsge models with inequality constraints. School of Economics Discussion Papers 1612, School of Economics, University of Surrey. Kim, S.H., Kollmann, R., Kim, J., (2010). Solving the incomplete market model with aggregate uncertainty using a perturbation method. J. Econ. Dyn. Control 34 (1), 50–58. Kumhof, M., Nunes, R., and Yakadina, I. (2010). Simple Monetary Rules under Fiscal Dominance. Journal of Money, Credit, and Banking, 42(1). Leeper, Eric. (1991).Equilibrium under Active and Passive Monetary and Fiscal Policies. Journal of Monetary Economics, 27, 129–47. Lipsey, R.G., and Lancaster, K. (1956). The General Theory of Second Best. The Review of Economic Studies, 24(1), 11–32. Marglin, S. (2021). Raising Keynes: A Twenty-First-Century General Theory, Harvard University Press McFadden, D. (2001).Economic Choices. American Economic Review McGrattan, E.R., (1996). Solving the stochastic growth model with a finite element method. J. Econ. Dyn. Control 20 (1–3), 19–42. Mehl, A., and Reynaud, J. (2005). The Determinants of Domestic "Original Sin" in Emerging Market Economies, ECB (Eurosystem) Working Paper Preston, B., Roca, M., (2007). Incomplete Markets, Heterogeneity and Macroeconomic Dynamics. Technical Report. Sargent, T. J. and N. Wallace (1981). Some unpleasant monetarist arithmetic. Quarterly Review, 5. Schmitt-Grohé, Stephanie, and Martin Uribe. (2005). Optimal fiscal and monetary policy in a medium-scale macroeconomic model. NBER Macroeconomics Annual 20: 383-425. Schmidt, S. (2024). Monetary-fiscal policy interactions when price stability occasionally takes a back seat . ECB-Eurosystem Working Paper No. 2024/2889 Sims, Chris A. (2005). Limits to Inflation Targeting. In The Inflation Targeting Debate, edited by Ben Bernanke and Michael Woodford. Chicago: University of Chicago Press. Train, K. (2002). Discrete Choice Methods with Simulation}, Cambridge University Press. Visco, I. (2023).Inflazione e Politica Monetaria. Laterza. Visco, I. (2022). Inflazione e Politica Monetaria. Lezione I “Ugo La Malfa”, Camera dei deputati, Aula dei gruppi parlamentari, Roma. Train, K. (2002). Discrete Choice Methods with Simulation, Cambridge University Press. Woodford, Michael. (1996). Control of the Public Debt: A Requirement for Price Stability? NBER Working Paper No. 5684. Woodford, Michael. (1998). Public Debt and the Price Level. Manuscript, Princeton University. Woodford, Michael. (2001). Fiscal Requirements for Price Stability. NBER Working Paper No. 8072. |
URI: | https://mpra.ub.uni-muenchen.de/id/eprint/125094 |