Inflation-stabilizing monetary and fiscal policy rules at and away from the lower bound

Abstract

We examine how fiscal policy can support monetary policy when nominal interest rates face an occasionally binding lower bound constraint. Within the conventional framework of active monetary policy and passive fiscal policy, the optimized fiscal rule features a strong response to inflation deviations from the central bank’s target. The inflation-stabilizing fiscal rule significantly reduces the deflationary bias and welfare costs associated with the lower bound constraint while maintaining debt sustainability. Counterfactual analysis for the U.S. shows that implementing the optimized fiscal rule during the pre-pandemic low-inflation period would have provided systematic support to monetary policy, lifting inflation closer to target when rates were at the lower bound and enabling an earlier rate lift-off.