Working Paper: CEPR ID: DP18002
Authors: Sebastian Schmidt
Abstract: What are the macroeconomic consequences of a government that is limited in its willingness or ability to raise primary surpluses, and a central bank that accommodates its interest-rate policy to the fiscal conditions?I address this question in a dynamic stochastic sticky-price model with endogenous shifts between an "orthodox'" and a "fiscally-dominant'" policy regime.The risk of future regime shifts has encompassing effects on equilibrium. Inflation is systematically higher than it would be if fiscal policy always adjusted its primary surplus sufficiently and monetary policy was solely concerned with price stability. This inflation bias is increasing in the real value of government debt. Regime-switching probabilities are not invariant to policy. The central bank can attenuate the risk of a shift to the fiscally-dominant regime by raising the real interest rate sufficiently moderately when inflation increases. Lower fiscal dominance risk, in turn, mitigates the inflation bias.
Keywords: monetary policy; fiscal policy; fiscal dominance; inflation bias
JEL Codes: E31; E52; E62; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central bank's interest rate policy (E52) | risk of shifting to a fiscally dominant regime (E62) |
| risk of shifting to a fiscally dominant regime (E62) | equilibrium inflation (E31) |
| government debt level (H63) | central bank's deviation from the Taylor rule (E52) |
| central bank's deviation from the Taylor rule (E52) | failure in achieving price stability (E31) |
| real value of government debt (H63) | inflation bias (E31) |
| central bank raising real interest rates (E52) | lower fiscal dominance risk (E62) |
| lower fiscal dominance risk (E62) | diminished inflation bias (E31) |