Monetary–Fiscal Policy Interactions When Price Stability Occasionally Takes a Back Seat
What this paper finds — and why it matters
The paper builds a discrete-time DSGE model with Calvo sticky prices in which the public sector has two feedback rules that can hit corners, generating endogenous shifts between an “orthodox” regime and a “fiscally-dominant” regime. Fiscal policy sets the primary surplus as s̃_t = min(ϕb̃_{t−1}, s̄): the surplus tracks real debt with coefficient ϕ = 0.1 until the limit s̄ = 0.01 (1% of output in deviation from steady state; approximately 3% in level) binds. Monetary policy follows R̂_t = min(αp̂_t, R̄): a standard Taylor rule with coefficient α = 2.5 until the nominal interest rate cap R̄ ≈ 5% (annualized) is hit. When the surplus limit is slack — the orthodox regime — fiscal policy is locally passive and monetary policy is active in the sense of Leeper (1991). When the surplus limit binds — the fiscally-dominant regime — the central bank caps its policy rate to avoid aggravating fiscal stress, and price stability takes a back seat.
Calibration (Table 1): β = 0.995 (annual steady-state real rate ≈ 2%), σ = 1 (log utility), κ = 0.0093 (Calvo Phillips curve slope), η = 1 (inverse labor supply elasticity), θ = 10 (price elasticity of demand), ω = 0.8 (Calvo price-stickiness), α = 2.5, ϕ = 0.1, b/(4y) = 1 (100% debt-to-GDP), s̄ = 0.01, R̄ = 0.0074 in deviation from steady state (≈ 5% annualized), AR(1) coefficient ρ = 0.6, shock standard deviation σ_μ = 0.0016. The model is solved globally using a projection method to handle the kinks from the min operators.
In the fiscally-dominant regime, monetary policy is asymmetric: the central bank always lowers the rate for deflationary shocks but cannot raise it fully for large inflationary shocks (rate hits R̄). This stabilizes real debt in both shock directions while creating an asymmetric inflation response — inflation rises more in response to a positive cost-push shock than it falls for a negative shock of equal magnitude. This asymmetric profile is baked into agents’ expectations in all states of the world, including the orthodox regime, generating a systematic inflation bias that is increasing in the real value of government debt.
Simulation results (Table 2, based on 3,000 simulations of 1,000 quarters): the fiscally-dominant regime (surplus limit binding) occurs in 20% of periods, with an average duration of 3.6 quarters; the rate cap additionally binds in 10% of periods, with an average duration of 1.8 quarters.
Risky steady state (Table 3): The point to which the economy converges when transitory shocks have receded but agents fully internalize future regime-shift risk differs from the deterministic steady state: inflation is 27bp higher, output is 0.26pp lower, the real interest rate is 41bp higher, and the government debt-to-GDP ratio is 1.07pp higher. At the risky steady state the economy remains in the orthodox regime; all four effects stem from the inflation expectations channel.
Vicious-cycle mechanism: Higher debt raises the probability of fiscal dominance → larger inflation bias → higher real interest rate (the Taylor rule raises the nominal rate more than one-for-one with the inflation bias) → upward pressure on debt. The fiscal dominance risk is state-dependent: it increases with the cost-push shock and with the debt level (Figure 4).
Policy finding (Section 3.3 and Table 4): Because regime switches are endogenous, the central bank can reduce fiscal dominance risk by responding more moderately to inflation — lowering α from 2.5 to 1.5 — while still satisfying the Taylor principle (α > 1/β). A lower α attenuates the increase in debt servicing costs after an inflationary shock, requiring larger shocks to push the surplus limit to bind. Under α = 1.5: the fiscal dominance regime frequency falls to 0%; the risky steady-state inflation bias falls to essentially zero (0.01bp); inflation volatility falls from 1.93% to 1.89% — the volatility-reducing effect of avoiding fiscal dominance dominates the direct volatility-raising effect of a weaker response. At α ≈ 1.5, welfare (measured as the linear-quadratic loss −E[π̂² + λŷ²] with λ = κ/θ) is higher than at α = 2.5 (Figure 6). By contrast, under the benchmark configuration (no fiscal dominance risk), welfare falls monotonically as α declines.
Extension 1 — Distortionary taxation (Section 4.1): Replacing lump-sum taxes with a labor income tax (τL = 24%, cap = 25%) amplifies the mechanism. The risky steady-state inflation bias rises to 0.59pp; fiscal dominance occurs in 29% of periods; the rate cap binds in 16% of periods. The amplification reflects that the tax rate enters the Phillips curve, creating an additional cost-push channel when the tax cap binds.
Extension 2 — Passive monetary policy in the fiscally-dominant regime (Section 4.2): When the central bank switches to a passive rule with αF = 0.95 (rather than imposing a hard rate cap), the inflation bias is 0.23pp and fiscal dominance occurs in 15% of periods.
Scope conditions: The model features a representative household, a single cost-push shock, and lump-sum taxes in the baseline. All quantitative results are specific to the parameterization in Table 1, targeting 100% debt-to-GDP. Agents are assumed to have perfect knowledge of the central bank’s policy rule; in practice, a moderate α could be misinterpreted as abandoning the Taylor principle. The analysis is primarily conceptual; the paper notes that extending to a full-fledged multi-shock quantitative model is left for future work.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. What are the two regimes in the model, and how do transitions occur?
The orthodox regime is characterized by an active central bank (α > 1/β, Taylor principle satisfied) and a passive fiscal authority (surplus responds to debt, ϕ ∈ (1−β, 1)); the fiscally-dominant regime arises when the fiscal surplus hits its upper limit s̄ = 0.01 and the central bank caps its nominal rate at R̄ ≈ 5% annualized to avoid deepening the fiscal stress. Transitions are driven entirely by the state of the economy: when real debt b̃_{t-1} crosses the threshold b̄ = s̄/ϕ from below following a sufficiently large inflationary cost-push shock, the surplus limit binds and the economy enters the fiscally-dominant regime. Exit occurs when a sequence of disinflationary shocks, together with the central bank’s rate cuts, lowers debt below the threshold. Both the entry and exit thresholds are determined by the structural parameters of the model, not set exogenously.
Q2. Why does fiscal dominance risk generate an inflation bias in the orthodox regime?
The key transmission channel runs through expectations: in the fiscally-dominant regime the central bank responds asymmetrically to shocks (always cutting for deflation, capped on the upside for large inflation), creating an asymmetric inflation distribution; agents rationally incorporate this skewness into their inflation expectations in all states — including the orthodox regime — pushing expected inflation above target; the Taylor rule then allows actual inflation to be persistently elevated because the response coefficient α = 2.5, while large, does not fully offset the expectations-induced inflation pressure. The upward inflation expectations shift appears in the forward-looking Phillips curve (equation 2): higher Etπ_{t+1} raises current inflation πt, and the Taylor rule’s response is insufficient to fully counteract the expectations-driven component of the inflation bias.
Q3. Why does the inflation bias increase with the debt level?
Higher beginning-of-period government debt reduces the buffer between current debt and the threshold b̄, so that any given realization of the cost-push shock has a higher probability of pushing debt over the threshold and triggering a shift to the fiscally-dominant regime next period; the larger this probability, the larger the expectations-driven inflation bias in the current period. This mechanism is illustrated in Figure 4, which shows the probability of fiscal dominance next period as an increasing function of the current cost-push shock (given debt near the risky steady state), and Figure 2, which plots the monotone increasing relationship between current debt and the inflation rate in both regimes.
Q4. How does the vicious cycle between inflation, interest rates, and debt operate?
The cycle works as follows: a larger inflation bias induced by higher debt triggers a stronger nominal interest rate response from the Taylor rule; in the orthodox regime this raises the real interest rate, which increases debt servicing costs and pushes real debt upward; higher debt in turn raises the probability of fiscal dominance, which amplifies the inflation bias in the next period. The cycle is self-reinforcing but not necessarily explosive in the baseline calibration — the model has a unique risky steady state at which these forces balance — but it does shift equilibrium outcomes permanently upward relative to the deterministic steady state: the real rate is 41bp higher, debt 1.07pp higher, and inflation 27bp higher at the risky steady state (Table 3).
Q5. Can the central bank break the cycle without abandoning price stability?
Yes: by lowering the Taylor rule coefficient from α = 2.5 to α = 1.5, the central bank reduces the increase in debt servicing costs after an inflationary shock, thereby making it less likely that the surplus limit binds; when the probability of fiscal dominance approaches zero, inflation expectations are anchored at the deterministic steady state and the inflation bias disappears. This works without violating the Taylor principle (α = 1.5 > 1/β ≈ 1.005) because the objective is not to tolerate more inflation at each point in time, but to reduce the regime-switch risk that is the source of the bias. Crucially, the central bank does not need to commit to any specific regime-change-contingent rule — modifying the response coefficient of the standard Taylor rule is sufficient.
Q6. Why does lower α also reduce inflation volatility, not just the bias?
In the regime-switching model there are two competing effects on inflation volatility when α falls: (i) a direct volatility-raising effect because a weaker rate response gives more room for cost-push shocks to move inflation, and (ii) a volatility-reducing effect because the fiscally-dominant regime — where inflation is amplified by asymmetric monetary policy — is less frequently visited. At α = 1.5, effect (ii) dominates: the standard deviation of annualized inflation falls from 1.93% (α = 2.5) to 1.89% (α = 1.5). This contrasts with the benchmark configuration (no fiscal dominance possible), where effect (i) always dominates and welfare falls monotonically with α.
Q7. What does distortionary taxation add to the baseline result?
When the government adjusts a labor income tax rate (τL capped at 25%, baseline 24%) instead of lump-sum taxes, the inflation bias is amplified to 0.59pp (versus 0.27bp in the baseline) and the fiscally-dominant regime occurs 29% of the time (versus 20%). The amplification comes from two sources: the labor tax rate appears directly in the New Keynesian Phillips curve (equation 9), so a binding tax cap generates an additional cost-push effect that raises inflation independently of the interest rate channel; and output is increasing in the debt level in the fiscally-dominant regime (because a higher debt level makes the rate cap more likely, raising output through the demand channel), which further increases the primary surplus through the tax base, partly offsetting the tax cap but complicating the fiscal dynamics.
Q8. How does the passive monetary policy extension compare to the baseline?
When the central bank switches to a passive rule αF = 0.95 in the fiscally-dominant regime (rather than imposing a hard nominal interest rate cap), the inflation bias at the risky steady state falls to 0.23pp and the fiscally-dominant regime occurs in 15% of periods — both improvements over the baseline (0.27bp, 20%), but the mechanism is somewhat different. Under the passive rule, there is no hard constraint on the interest rate, so the central bank can still raise rates to some extent in response to inflationary shocks in the fiscally-dominant regime, reducing the asymmetry in the inflation response. The rate cap extension (baseline) is the more extreme case in which the constraint is fully binding.
Q9. How does this paper differ from exogenous regime-switching models?
The key difference is that in this model the probability of a regime shift is not exogenous — it is a function of the current state (debt level, cost-push shock) and of the policy parameters (α, ϕ, s̄, R̄); this means the central bank can influence regime-change risk by changing its policy rule, which is not possible in models like Davig and Leeper (2006), Bianchi and Melosi (2017, 2019), or Bianchi and Ilut (2017) where switching probabilities are fixed Markov parameters. The ability of the central bank to manage regime-switch risk is the novel channel through which monetary policy can attenuate the inflation bias without abandoning price stability — a result that has no counterpart in models where the fiscal authority’s behavior is exogenous.
Key concepts
orthodox regime : the policy configuration in which the fiscal surplus limit is slack (s̃_t < s̄) and the central bank follows a standard Taylor rule (R̂_t = αp̂_t with α > 1/β); fiscal policy is passive and monetary policy is active in Leeper’s (1991) sense.
fiscally-dominant regime : the policy configuration in which the fiscal surplus limit binds (s̃_t = s̄) because the real value of government debt is sufficiently high, and the central bank caps its nominal interest rate at R̄ to prevent fiscal stability from deteriorating further; monetary policy becomes fiscally accommodative.
risky steady state : the point to which the economy converges when transitory shocks have receded but agents fully incorporate future regime-shift risk into their expectations; it differs from the deterministic steady state by an inflation bias of 27bp, a real interest rate premium of 41bp, an output shortfall of 0.26pp, and an additional 1.07pp of government debt (all in the baseline calibration).
inflation bias : the systematic elevation of equilibrium inflation above the price stability target that arises from the risk of future fiscal dominance episodes; it is increasing in the real value of government debt and is present even in periods when the economy is in the orthodox regime, because agents rationally incorporate fiscal dominance risk into their expectations.
endogenous regime switching : the feature of the model that distinguishes it from earlier regime-switching frameworks — the probability of a shift to the fiscally-dominant regime is a function of the current state of the economy (debt, cost-push shock) and of the policy parameters, so the central bank can influence regime-change risk through its choice of the Taylor rule coefficient.
vicious cycle : the self-reinforcing dynamic between debt, fiscal dominance risk, the inflation bias, and the real interest rate: higher debt raises fiscal dominance risk → larger inflation bias → higher real rate (via Taylor rule) → higher debt servicing costs → further upward pressure on debt.