Consequences of Fiscal Risk to Optimal Monetary Policy

Abstract We study the optimal monetary policy of a New Keynesian economy on the brink of fiscal dominance. The model features a Markov switching structure to incorporate regime uncertainty. Switching probabilities can be either exogenous or endogenous. We find that a fiscal risk entails a welfare loss and breaks the “divine coincidence” because perfect price stabilization becomes counterproductive when monetary policy affects debt dynamics and agents anticipate regime changes. In this environment, the optimal inflation coefficient in the Taylor rule is decreasing on the fiscal risk, and the optimal regime choice ultimately depends on government credibility.