DP12164 The Dire Effects of the Lack of Monetary and Fiscal Coordination

Author(s): Francesco Bianchi, Leonardo Melosi
Publication Date: July 2017
Keyword(s): coordination, emergency budget, liquidity traps, Markov-switching models, Monetary and ?scal policies
JEL(s): D83, E31, E52, E62, E63
Programme Areas: International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12164

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.