Effects of fiscal policy on the durability of low inflation regimes

This paper deals with the interaction of fiscal and monetary policy when the central bank is pursuing a price stability-oriented monetary policy. In particular, we study the durability of the price stability regime when public debt accumulates as a result of ultimately unsustainable deficits. The growth of indebtedness causes the collapse of the price stability regime after a period of rising deficits. The budget deficit is endogenously determined in the model, as a result of government’s decisions on how to finance its expenditure. The alternative methods of finance are taxes, debt, and seigniorage. Under the price stability regime, only the first two methods are available, but in the long run taxes and seigniorage are the only alternatives. The price stability regime collapses when the public debt reaches an edogenously determined threshold, which makes reneging on price stability as attractive as accumulating more tax burden for the future. We are able to solve for the critical level of debt, the timing of the collapse, and the reaction of taxes to the collapse of the price stability regime. The critical level of debt depends, inter alia, on the level of government consumption, the real interest rate, the velocity of money, and the efficiency-effects of taxation. The results are illustrated by several numerical simulations.

Introduction: Central banks are usually thought to be responsible for maintaining price stability. However, the interaction of fiscal and monetary policies may lessen the power of the central bank to control the price level. If the fiscal policy authority can rely on seigniorage revenues when considering different ways to balance the budget,central bank’s ability to fight for price stability is limited. Therefore, budget deficits and high debt levels may threaten low inflation policy targets because the government has always a temptation to use seigniorage to reduce its financial burden. This is especially the case if the central bank is not very independent.Questions considering independence of european central banks and especially the interaction of fiscal and monetary policies are important issues in this study as well as in public debate nowadays. All European countries are committed to low inflation, which could be threatened, at least to some extent, by loose fiscal policies. For this reason, the need for fiscal discipline has quite often been stressed by euroarea monetary policy authorities. Fiscal discipline in all euroarea countries is thought to be necesasry, if not sufficient to secure the ability of the European Central Bank to fight for price stability. Deficit and debt requirements ensure that no country with fiscal discipline is hurt by some other country that might use loose fiscal policy for its own purposes. Question concerning how the sustainability of low inflation policy regime depends on fiscal policy is very important when deciding what kind of norms fiscal policy should follow.

Author: Tapio Pohjola

Source: Research Discussion Papers, Bank of Finland

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