Monetary policy and fiscal limits with no-default

- This paper discusses monetary and fiscal policy interactions in closed economies with distortionary taxation, capital accumulation, and liquidity constraints.
- The issue of nominal determinacy implies a new role for monetary policy.
- Open market operations have a crucial role in the stabilization of government debt.
- Some interactions can substantially moderate the extent of fiscal inflation and fiscal consolidation required to stabilize government debt.
- Impulse responses show policy experiments that can offset a permanent shock to transfers, and policies that lead to a default.

This paper discusses monetary and fiscal policy interactions that stabilize government debt. Two distortions prevail in the model economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include a ceiling on the equilibrium debt-to-GDP ratio, zero or negative elasticity of tax revenues, and a political intolerance of raising tax rates. At the fiscal limit two mechanisms restore solvency: fiscal inflation, which reduces the real value of nominal debt, and open market operations, which diminish the size of government debt held by the private sector. Three regimes achieve this goal. In all regimes monetary policy is passive. In all regimes a muted tax response to government debt is consistent with equilibrium. The propensity of a fiscal authority to smooth output is found to determine what is an acceptable response (in the form of tax rate changes) to the level of government debt, while monetary policy determines the timing and magnitude of fiscal inflation. Impulse responses show that the inflation and tax hikes needed to offset a permanent shock to transfers are lowest under nominal interest rate pegs. In this regime, most of the reduction in the real value of government debt comes from open market purchases.