Transmission of macroeconomic shocks in an oil-exporting economy: A hypothetical scenario of fiscal dominance

This paper compares the transmission of structural macroeconomic shocks in an oil-exporting economy under two alternative regimes of monetary and fiscal policy coordination. The first is the inflation targeting regime, with active monetary policy and passive fiscal policy. The second is a hypothetical fiscal dominance regime, with active fiscal policy and passive monetary policy. The analysis uses a New Keynesian dynamic stochastic general equilibrium (DSGE) model with an export-oriented oil and gas sector and non-Ricardian households. The model also includes a detailed budget constraint that distinguishes between oil and gas revenues and other revenues. An instrument rule for government transfers models passive or active behaviour by the fiscal authorities. The paper proposes a new transfer rule based on an error-correction mechanism, which differs from the standard specifications in the fiscal dominance literature. Under this rule, fiscal imbalances are stabilised through the erosion of the real value of both debt obligations and transfer payments to economic agents. This leads to a more moderate rise in prices and less pronounced domestic currency depreciation than under standard instrument rules, especially in response to oil shocks. However, fiscal dominance is more inflationary and generates larger output and inflation responses to shocks, indicating greater macroeconomic instability.