Monetary Instrument Problem Revisited: The Role of Fiscal Policy

Abstract

The monetary instrument problem is examined in an endowment economy model with various stochastic disturbances, with minimizing the variance of inflation as the policy objective. Following current developments in the theory of fiscal determination of the price level, active or passive fiscal policy is specified to guarantee a unique equilibrium for different monetary policies. The responses of inflation to various structural disturbances in the constant money growth rate-passive fiscal (the active monetary-passive fiscal regime, or the conventional regime where the Ricardian equivalence theorem and the Quantity Theory of Money hold) and the constant interest rate-active fiscal regime (the passive monetary-active fiscal regime, or the regime where fiscal policy determines the price level) are examined. The results are explained based on the role of monetary and fiscal policies in financing government deficit changes and satisfying the government budget constraint in each regime, which is different from the explanations of past research following Poole.

Keywords: monetary instrument problem, variance of inflation, fiscal policy, nominal government debt, fiscal theory of the price level

JEL Classification: E63, E52, E31