Monetary–Fiscal Policy Interactions When Price Stability Occasionally Takes a Back Seat

Abstract What are the macro‐economic consequences of a government that is limited in its willingness or ability to raise primary surpluses, and a central bank that accommodates its interest‐rate policy to the fiscal conditions? I address this question in a dynamic stochastic sticky‐price model with endogenous shifts between an “orthodox” and a “fiscally‐dominant” policy regime. The risk of future regime shifts has encompassing effects on equilibrium. Inflation is systematically higher than it would be if fiscal policy always adjusted its primary surplus sufficiently and monetary policy was solely concerned with price stability. This inflation bias is increasing in the real value of government debt. Regime‐switching probabilities are not invariant to policy. The central bank can attenuate the risk of a shift to the fiscally‐dominant regime by raising the real interest rate sufficiently moderately when inflation increases. Lower fiscal dominance risk, in turn, mitigates the inflation bias.