Optimal Fiscal Implications of Optimal Unconventional Monetary Policy

Abstract

This paper studies the joint determination of optimal fiscal and unconventional and conventional monetary policy in a medium-scale macroeconomic model with financial intermediaries. An agency problem between borrowers and lenders makes financial frictions endogenous and makes banks facing endogenous balance sheet constraints. The main result is that taking active fiscal policy explicitly into account leads to significant changes in implications of central banks direct lending programs, which are considered to be “the most important dimension of their balance sheet activities”. In the calibrated exogenous-policy model the balance sheet constraints tighten and a negative financial shock results in a financial crisis. In this case, unconventional monetary policy is effective in ameliorating the crisis. We then endogenize fiscal and monetary instruments and solve for the optimal policy. We explicitly solve for the optimal fraction of private credit intermediation by the central bank. In the presence of credit market intervention the Ramsey planner calls for extremely large long-run labor income or consumption tax subsidy. This is because the government issues short-term riskless debt and buys long-term risky assets and obtains large revenues from its asset-purchase policies, due to the assumed imperfect financial markets and abnormal excess returns. Furthermore, the optimal dynamics of the model with credit policy intervention feature extremely volatile distortionary taxes and government liabilities, which act as shock absorbers of negative financial innovations. With active fiscal policy the Ramsey dynamics do not imply that the central bank direct lending policy is effective in offsetting large financial disturbances, even under credit scarcity.