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Simple Monetary Rules under Fiscal Dominance
Author(s) -
KUMHOF MICHAEL,
NUNES RICARDO,
YAKADINA IRINA
Publication year - 2010
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/j.1538-4616.2009.00278.x
Subject(s) - economics , dominance (genetics) , interest rate , debt , government debt , monetary economics , inflation (cosmology) , welfare , taylor rule , nominal interest rate , monetary policy , real interest rate , macroeconomics , central bank , market economy , biology , biochemistry , physics , theoretical physics , gene
This paper asks whether interest rate rules that respond aggressively to inflation, following the Taylor principle, are feasible in countries that suffer from fiscal dominance. We find that if interest rates are allowed to also respond to government debt, they can produce unique equilibria. But such equilibria are associated with extremely volatile inflation. The resulting frequent violations of the zero lower bound make such rules infeasible. Even within the set of feasible rules the welfare optimizing response to inflation is highly negative. The welfare gain from responding to government debt is minimal compared to the gain from eliminating fiscal dominance.