Navigating by falling stars: monetary policy with fiscally driven natural rates

Summary

Focus

The natural rate (r*), that is the long-term real interest rate, is commonly assumed to depend only on structural parameters, such as productivity growth or demographics. This assumption doesn't hold when we move from the standard complete-market representative-agent framework towards a heterogeneous-agent New Keynesian (HANK) model. In this case, the natural rate depends on the stock of public debt.

Contribution

We study a new type of monetary-fiscal policy interaction in a HANK model with a fiscal block. If the treasury changes the long-run stock of public debt, the natural rate moves. The central bank may then either incorporate the new natural rate into its monetary policy rule or ignore it, which will influence long-term inflation expectations.

Findings

There is a minimum level of debt below which steady-state inflation deviates from its target due to the zero lower bound on nominal rates. We analyse the response to a debt-financed fiscal expansion and quantify the impact of different timings in the adaptation of the monetary policy rule. We also quantify the performance of alternative monetary policy rules that do not require an assessment of the natural rate. We validate our findings with a series of empirical estimates.

Abstract

We study a new type of monetary-fiscal interaction in a heterogeneous-agent New Keynesian model with a fiscal block. Due to household heterogeneity, the stock of public debt affects the natural interest rate, forcing the central bank to adapt its monetary policy rule to the fiscal stance to guarantee that inflation remains at its target. There is, however, a minimum level of debt below which the steady-state inflation deviates from its target due to the zero lower bound on nominal rates. We analyze the response to a debt-financed fiscal expansion and quantify the impact of different timings in the adaptation of the monetary policy rule, as well as the performance of alternative monetary policy rules that do not require an assessment of the natural rates. We validate our findings with a series of empirical estimates.

JEL classification: E32, E58, E63

Keywords: HANK models, natural rates, fiscal shocks