Recently, central banks expanded the size of their balance sheets in an attempt to mitigate the financial turmoil that began in 2008. In order to accomplish this goal, various unconventional operations were implemented, such as a liquidity provision to households and businesses, bailouts to financial institutions and foreign exchange swaps with foreign central banks. All of the above mentioned operations inflated the central banks balance sheets, and the magnitude of these operations was significant. These operations can be referred to as "quasi fiscal activities" because they do not conform to traditional monetary policy, which is used to stabilize inflation by controlling the policy interest rate.
Instead of being innate to central banks, most of these activities can be implemented by fiscal authorities. In this paper, a quasi fiscal policy is defined as any policy action that affects the central banksobalance sheets, with the exception of the traditional monetary policy mentioned above. For example, since credit easing operations alter the composition of the central banksoasset accounts, they are considered quasi fiscal policies. If losses are incurred from the central banksoassets and the fiscal authorities decide not to compensate the losses, then the fiscal authoritiesodecision is also a quasi fiscal policy because it decreases the central banks capital account.
Although current quasi fiscal operations are significant in size and assumed to be crucial for economic recovery, little economic theory is available to explain the possible macroeconomic consequences of these operations. Specifically, the effect of quasi fiscal policies on inflation needs to be explained because deflation has been one of the main concerns of policymakers during the implementation of such policies. This paper proposes a simple dynamic stochastic general equilibrium (DSGE) model, which incorporates quasi fiscal policies in order to address the following questions: 1) Do quasi fiscal policies and the central banks balance sheets affect inflation? and 2) Do the central banksobalance sheets have implications for policy interactions between the central banks and fiscal authorities?
Sargent and Wallace (1981) and Leeper (1991) connected monetary and fiscal policy by showing that one policy may impose restrictions on the other policy, and that the two policies should interact in a coherent way in order to deliver a unique equilibrium. In this conventional approach to policy interaction, the budget constraints of the central banks and fiscal authorities are consolidated into a single equation. In other words, conventional models implicitly assume that the fiscal authorities acknowledge the central banks liabilities and assets as their own liabilities and assets, and that the central banks losses are automatically compensated by the fiscal authorities. Due to these assumptions, in conventional models, the budget constraint of the central banks does not impose restrictions on the equilibrium.
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Quasi Fiscal Policies of Independent Central Banks and Inflation
