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The macroeconomic effects of monetary policy shocks under fiscal rules constrained by public debt sustainability

Marco A.F.H. Cavalcanti, Luciano Vereda, Rebeca de B. Doctors, Felipe C. Lima and Lucas Maynard

Economic Modelling, 2018, vol. 71, issue C, 184-201

Abstract: This paper studies the macroeconomic effects of monetary policy shocks when fiscal rules are constrained to ensure public debt sustainability. In such an economy, the rise in the interest rate following a monetary policy shock increases the cost of financing debt, thereby making a fiscal adjustment necessary to guarantee debt sustainability. The analysis is based on a DSGE model developed and calibrated to describe the Brazilian economy, where the effects of the interest rate on public debt service tends to be pronounced. The model incorporates a detailed public sector capable of intervening in the economy through several channels. Our simulations show that the magnitude of the reduction in GDP following a monetary policy shock varies considerably depending on the fiscal rule adopted. In particular, there is strong evidence that economic performance worsens when fiscal adjustment relies on public investment cuts.

Keywords: Monetary policy; Fiscal rules; Public investment; Public debt; Sacrifice ratio (search for similar items in EconPapers)
JEL-codes: E32 E62 H30 (search for similar items in EconPapers)
Date: 2018
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