 Dynamics and Optimal Monetary-Fiscal Policy in Fiscally Dominant Economies with Occasionally Inflexible Monetary AuthoritiesBiagio Rosso and Matteo Gatto MPRA Paper from University Library of Munich, Germany 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. 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 (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:125094 Access Statistics for this paper More papers in MPRA Paper from University Library of Munich, Germany Ludwigstraße 33, D-80539 Munich, Germany. Contact information at EDIRC. |
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