Working Paper

The Dire Effects of the Lack of Monetary and Fiscal Coordination

Abstract: What happens if the government?s willingness to stabilize a large stock of debt is waning, while the central bank is adamant about preventing a rise in inflation? The large fiscal imbalance brings about inflationary pressures, triggering a monetary tightening, further debt accumulation, and additional inflationary pressure. Thus, the economy will go through a spiral of higher inflation, output contraction, and further debt accumulation. A coordinated commitment to inflate away the portion of debt resulting from a large recession leads to better macroeconomic outcomes by separating the issue of long-run fiscal sustainability from the need for short-run fiscal stabilization. This strategy can also be used to rule out episodes in which the central bank becomes constrained by the zero lower bound.

Keywords: Monetary and fiscal policies; coordination; emergency budget; Markov-switching models; liquidity traps;

JEL Classification: D83; E31; E5; E62; E63;

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series

Publication Date: 2017-07-06

Number: WP-2017-19

Pages: 56 pages