Dominance score in the fiscal-monetary interaction

Abstract

The paper addresses a trade-off between the degree of fiscal dominance and fiscal and monetary sustainability conditions. The research aims at finding growth incentives in the complex fiscal-monetary environment. By testing the actual data, the study introduces the empirical specification of the non-linear relationship between the dynamics of broad money and public debt, which allows for interpolating the fiscal space. The study develops a Dynamic Stochastic General Equilibrium (DSGE) model for a small open developing economy that, in addition to several rigidities, such as deep habit formation, staggered pricing and wage stickiness, also incorporates the extended fiscal and monetary policy blocks, a composite lifetime utility-generating function, a low level of public investment efficiency and a negative relationship between the interest rate premium and foreign prices fluctuation. Employing the developed DSGE framework made it possible to outline a promising growth path in the policy trade-off between the degree of fiscal dominance and the persistence of sustainability conditions. The modeling results revealed that short-term growth outweighs the crowding-out effect and that excessive macroeconomic volatility, especially price and debt dynamics, is well-curbed. The calculation of elasticity functions allowed for calibrating the interrelationship between the maximum growth rate of output, the degree of fiscal dominance and the persistence of fiscal and monetary sustainability conditions. The study highlights two key messages. The public debt ratio is not the final indicator to determine fiscal sustainability conditions. The degree of dominance, not the ratio of public debt to output, matters most that fiscal and monetary authorities should consider in pursuing growth incentive policy.

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