Working Paper: CEPR ID: DP14720
Authors: Francesco Bianchi; Renato Faccini; Leonardo Melosi
Abstract: The COVID pandemic found policymakers facing constraints on their ability to react to an exceptionally large negative shock. The current low interest rate environment limits the tools the central bank can use to stabilize the economy, while the large public debt curtails the efficacy of fiscal interventions by inducing expectations of costly fiscal adjustments. Against this background, we study the implications of a coordinated fiscal and monetary strategy aiming at creating a controlled rise of inflation to wear away a targeted fraction of debt. Under this coordinated strategy, the fiscal authority introduces an emergency budget with no provisions on how it will be balanced, while the monetary authority tolerates a temporary increase in inflation to accommodate the emergency budget. In our model the coordinated strategy enhances the efficacy of the fiscal stimulus planned in response to the COVID pandemic and allows the Federal Reserve to correct a prolonged period of below-target inflation. The strategy results in only moderate levels of inflation by separating long-run fiscal sustainability from a short-run policy intervention.
Keywords: monetary policy; fiscal policy; emergency budget; shock specific rule; COVID
JEL Codes: E50; E62; E30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Emergency budget (H68) | Fiscal stimulus (E62) |
| Monetary authority's tolerance for inflation (E31) | Effectiveness of fiscal stimulus (E62) |
| Fiscal stimulus (E62) | Economic output (E23) |
| Inflation (E31) | Real interest rates (E43) |
| Coordinated fiscal and monetary policies (E63) | Stabilization of the economy (E63) |
| Orthodox approach (raising taxes and cutting expenditures) (E62) | Prolonged economic contraction (E32) |
| Orthodox approach (raising taxes and cutting expenditures) (H69) | Higher debt-to-GDP ratio (H69) |