Ebook Central Bank Balance Sheet Concerns, Monetary and Fiscal Rules, and Macroeconomic Stability
Disinflation programs set in motion in the 1980s have enjoyed great success across both industrial and developing economies. Price stability, defined as low and stable inflation, has become a widespread reality. Central bank (CB) independence is now firmly enshrined in the legal framework of most industrial economies, and the credibility of central bankers engaged in rule based policy making has been greatly enhanced.
Hardly did the celebrations of the demise of the “Great Inflation” begin when the alarm of a deflationary spiral sounded and the fear of the economies hitting the zero lower bound (ZLB) on nominal interest rates and of falling into the infamous “liquidity trap” began to trouble the minds of many central bankers around the world. The decade-long “Great Recession” of Japan and the recent economic slowdown in the US and in some major European economies, combined with very low and occasionally negative inflation rates, raised the specter of a new era of deflationary recessions and of a loss of monetary policy effectiveness in an environment of price stability.
In an important seminal paper, Sargent and Wallace (1975) first illustrated how price level indeterminacy arises under a pure interest rate peg in a rational-expectations flexible-price model. McCallum (1981, 1983) argued that a commitment to feedback from endogenous state variables renders the rational expectations equilibrium (REE) determinate. Taylor (1993) pro-posed an interest rate rule that targets inflation rate and output gap. It has been shown that under the Taylor Principle which dictates that the CB raises interest rate by more than one-to-one in response to an increase in inflation, such a rule, when coupled with a passive fiscal policy that ensures fiscal solvency, guarantees local uniqueness of the REE and promotes macroeconomic stability.
In a recent paper, Benhabib, Schmitt-Grohé and Uribe (2001b) questioned the local determinacy result for an active Taylor rule. They demonstrated that such a result may be sensitive to specifications of preferences and technology, for instance, when money enters the production function, and when money and consumption are Edgeworth substitutes. Furthermore, when a Taylor rule is constrained by the ZLB on the nominal interest rate, Benhabib, Schmitt-Grohé and Uribe (2001a, 2002) uncovered a second, low-inflation equilibrium, besides the desirable target equilibrium. The low inflation equilibrium has the characteristics of a liquidity trap. In this case, more complex dynamics emerge and the possibility of macroeconomic instability is greater. The focus on local determinacy is misleading when multiple steady state equilibria arise naturally, a global analysis may be imperative.
Extending the line of argument followed in Sargent and Wallace (1981), Leeper (1991), Sims (1994) and Woodford (1994, 1995, 1996, 2003) showed that fiscal policy is no less important than monetary policy in price level determination. In fact, local uniqueness under an interest rate rule may be restored by a reconsideration of fiscal policy and the government budget constraint. In a series of papers, Sims (1997, 1999, 2001, 2003) has been a tireless advocate of closer monetary-fiscal cooperation as the institutional setup better suited to weather situations of severe economic distress. For him, monetary policy rules without adequate fiscal backup are fundamentally flawed and may lead to greater macroeconomic instability. CB independence and credibility built up in the crusade against high and persistent inflation may hurt, rather than benefit an economy in a deflationary environment with nearly binding ZLB on nominal interest rates.
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