Abstract
ABSTRACTThis paper examines the policy challenges that a country faces when it wants to both reduce inflation and maintain a sustainable external position. Robert Mundell’s policy assignment framework suggests that these two goals may be mutually incompatible unless monetary and fiscal policies are properly coordinated. Unfortunately, if the fiscal authority is unwilling to cooperate – a case of fiscal intransigence – and central banks pursue a disinflation on a “go it alone” basis, their country’s external position may further deteriorate. A dynamic analysis shows that if the central bank itself lacks credibility, it must rely even more on cooperation from the fiscal authority. The paper thus extends Sargent and Wallace’s “unpleasant monetarist arithmetic” to an open economy: a central bank’s efforts to stabilize prices and output using a “go it alone” strategy (no help from the fiscal) may be thwarted by external factors: more external debt, higher risk premia and exchange rate passthrough.
Highlights
In an open economy, macroeconomic stabilization—the elimination of imbalances, both external and internal—is a fundamental goal
6 In this analysis, we focus on the case where Expanded Marshall-Lerner (EML) holds
This paper has focused on the policy challenges a country faces when it wants to both reduce inflation and maintain a sustainable external position
Summary
Macroeconomic stabilization—the elimination of imbalances, both external and internal—is a fundamental goal. Purpose of such a calculation is to show the adjustment of the real exchange rate that is required to eliminate the external imbalance without the help of a corresponding fiscal adjustment At first blush, such an exercise may seem uninteresting, since it assumes that the central bank has essentially abandoned its traditional goal of internal stability. In Part II we extend the external sustainability/real exchange rate calculation by including both a monetary (exchange rate) and a domestic absorption (fiscal) component We combine this equation with a similar oneshot or static “back of the envelope” expression for internal imbalances (inflation, output gap). If the fiscal authority fails to cooperate, the central bank will have to tighten even more to reach its inflation objective than otherwise This means even more real exchange rate appreciation, more deterioration of the net export deficit, and higher external debt. The key lesson from Mundell’s static assignment framework, namely the importance of coordination between the fiscal and monetary authorities, can be extended to a dynamic framework as well
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