Disinflation, external vulnerability, and fiscal intransigence: some unpleasant Mundellian arithmetic

Evan C. Tanner

Journal of Applied Economics, 2019, vol. 22, issue 1, 403-436

Abstract: This paper examines the policy challenges that a country faces when it wants to both reduce inflation and maintain a sustainable external position. Robert Mundell’s policy assignment framework suggests that these two goals may be mutually incompatible unless monetary and fiscal policies are properly coordinated. Unfortunately, if the fiscal authority is unwilling to cooperate – a case of fiscal intransigence – and central banks pursue a disinflation on a “go it alone” basis, their country’s external position may further deteriorate. A dynamic analysis shows that if the central bank itself lacks credibility, it must rely even more on cooperation from the fiscal authority. The paper thus extends Sargent and Wallace’s “unpleasant monetarist arithmetic” to an open economy: a central bank’s efforts to stabilize prices and output using a “go it alone” strategy (no help from the fiscal) may be thwarted by external factors: more external debt, higher risk premia and exchange rate passthrough.

Date: 2019
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DOI: 10.1080/15140326.2019.1644718

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