1) The document discusses how monetary policy performance is affected by fiscal policy and whether monetary policy should depend on the fiscal policy regime. 2) It finds that monetary policy should be active when fiscal policy is passive to ensure determinacy and stability, while an interest rate peg may be needed if fiscal policy is consistently active. 3) The research considers different cases where fiscal policy could be overall passive, active, or switching between regimes, and finds regime-dependent monetary policy is sometimes necessary to minimize inflation variability.

1. Monetary Policy and Research Department, Bank of Finland
Performance of Simple Interest Rate
Rules Subject to Fiscal Policy
Nigel McClung

2. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Monetary Policy Performance
What does a good monetary policy accomplish?
• Good monetary policy stabilizes inflation gap.
• Good monetary policy manages expectations.
• Monetary policy should rule out bad equilibria (determinacy).
• Monetary policy should stabilize expectations if people have imperfect
information (E-stability).
To identify good policy, we must consider features of the economy
that matter for inflation and expectations.
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3. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Fiscal Policy Matters
• Fiscal policy stance on debt impacts inflation (Leeper, 1991)
• Debt-stabilizing (passive) fiscal policy → hawkish (active) monetary policy.
• Non-responsive (active) fiscal policy → weak (passive) monetary policy.
• Is fiscal policy passive or active?
• Evidence of recurring active and passive regimes (e.g. Davig and Leeper
(2006, 2011), Bianchi and Ilut (2017), Bianchi and Melosi (2017), Chen,
Leeper, Leith (2018)).
• After monetary dominance period, recent crises raise issue of fiscal
dominance.
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4. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Research Questions
• Should recurring changes in the fiscal stance matter for monetary
policy?
• Regime-dependent monetary policy: monetary policy is active (passive)
when fiscal policy if passive (active).
• Regime-dependent policy might be necessary for determinacy/E-stability.
• Regime-dependent policy may minimize inflation gap variance.
• How can central banks respond to unobserved regime change?
• The fiscal regime depends on unobserved beliefs about debt sustainability.
• Budget processes are complicated.
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5. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Results
1. Three cases:
1. Overall Passive (OP): Ricardian policy → active monetary policy all the
time.
2. Overall Active (OA): Non-Ricardian + strong active fiscal regimes →
interest rate peg all the time.
3. Overall Switching (OS): Non-Ricardian + strong passive fiscal regimes
→ temporary active monetary policy is necessary for determinacy.
2. Estimated models suggest OP, OS and OA cases are relevant.
3. Simple strategies for when fiscal regimes are unobserved.
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6. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Brief Literature Review
• Generalizing Leeper (1991)
• Ascari et al. (2020).
• Cho and Moreno (2019).
• Optimal Monetary Policy with Fiscal Policy
• Chen, Leeper, Leith (2020).
• Learning Literature
• Orphanides and Williams (2007).
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Simple Model: Fiscal Authority
• Tax households lump-sum and spend → real surplus/deficit (𝜏).
• Issue nominal bonds to finance deficits (𝜏 < 0).
• Fiscal policy rule:
𝜏 𝑡 = 𝜸 𝒕 𝒃 𝒕−𝟏 + 𝛾 𝑦,𝑡 𝑦𝑡 + ⋯
• 𝒃 𝒕−𝟏 is real government debt (percent dev. from steady state).
• Passive fiscal policy: 𝜸 𝒕 > 𝒓
• Active fiscal policy: 𝜸 𝒕 < 𝒓
• 𝜸 𝒕 assumes passive or active value following a Markov process.
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8. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Simple Model: Central Bank
• Central Bank attempts to stabilize 𝝅 𝒕 around 𝝅∗
by adjusting nominal
interest rate rule according to:
𝑖 𝑡 = 𝜌𝑡 𝑖 𝑡−1 + (1 − 𝜌𝑡)(𝝓 𝒕(𝝅 𝒕−𝝅∗
) + 𝜙 𝑦,𝑡 𝑦𝑡)+…
• Passive monetary policy: 𝝓 𝒕 <1
• Active monetary policy: 𝝓 𝒕 >1
• Central bank may choose to change its stance (e.g. 𝝓 𝒕) depending on
whether fiscal policy is active or passive.
• If 𝝓 𝒕 = 𝝓 for all t then monetary policy is regime-independent.
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9. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Approach
1. Specify a fiscal policy.
2. Search for interest rate rule calibration that:
a) Minimizes inflation gap variance.
b) Supports a unique (determinate) and E-stable equilibrium using
techniques from Cho (2016, 2020) and McClung (2020).
3. Repeat for many fiscal policies and many calibrations of the
aggregate demand and Phillips curve equations.
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10. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Results
• Policy is either Ricardian (i.e. debt-stabilizing) or non-Ricardian
(Ascari et al., 2020).
• If policy is Ricardian (Overall Passive), then regime-independent
active monetary policy is preferable.
• Ricardian policy → debt not relevant for inflation + Taylor Principle
sufficient for determinacy and E-stability.
• A Ricardian policy can feature persistent, frequent active fiscal regimes.
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11. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Results
Two cases under non-Ricardian policy:
1. Overall Active: sufficiently strong, persistent active fiscal
regimes → regime-independent interest rate peg.
2. Overall Switching: sufficiently strong, persistent passive fiscal
regimes → regime-dependent monetary policy is necessary for
determinacy and E-stability.
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12. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Empirical Considerations
• What do the data say about OA, OP, and OS fiscal policies?
• Bianchi and Ilut (2017), Bianchi and Melosi (2017), Chen, Leeper, Leith
(2018) → OS/OP
• Davig and Leeper (2006, 2011)→ OS/OA
• Important Limitations:
• Beliefs about the future matter most.
• Estimates reflect persistent passive fiscal policy during the Great
Moderation—do people expect a return to passive monetary policy?
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13. | For internal use | BOF/FIN-FSA-CONFIDENTIAL
Performance of Interest Rate Rules in Estimated Models
Counterfactual analysis using full system of equations for estimated
models:
• Bianchi and Ilut (2017), Davig and Leeper (2011): preferred
monetary policy features active-passive switching.
• Bianchi and Melosi (2017): OP fiscal policy → regime-independent
active policy.
• Davig and Leeper (2006): OA fiscal policy→interest rate peg.
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Policy with Unobserved Regimes
1. Hidden State Interest Rate Rule:
𝑖 𝑡 = Pr 𝛾𝑡 < 𝑟 𝑖 𝑡
𝐴
+ (1 − Pr 𝛾𝑡 < 𝑟 ) 𝑖 𝑡
𝑃
𝑖 𝑡
𝑗
= 𝜌𝑗 𝑖 𝑡−1 + 1 − 𝜌𝑗 𝜙𝑗 𝜋 𝑡 + 𝜙 𝑦,𝑗 𝑦𝑡
• Pr 𝛾𝑡 < 𝑟 estimated recursively.
• Novel model of adaptive learning with hidden regimes→ new stability concept.
• Previous results robust to unobserved regimes.
2. Debt-Dependent Inflation Target
• 𝜋∗
increasing in 𝑏𝑡−1.
• Determinacy, E-stability with active monetary and active fiscal policy.
• Increases inflation gap variance.
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Implications for the current environment
• A period of active fiscal policy does not always imply fiscal
dominance.
• Expectations of future policy matter—do people expect future fiscal
surpluses?
• In some cases, passive monetary policy destabilizes inflation
under fiscal dominance (i.e. non-Ricardian fiscal policy).
• Active monetary regimes can help stabilize inflation.
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Conclusion
Should recurring fiscal regimes changes matter for monetary policy?
• Dominant active fiscal regime calls for interest rate peg.
• Dominant passive fiscal regime calls for active monetary policy.
• In some cases, active and passive monetary regimes are
necessary.
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