Monetary policy with a fiscal constraint

Abstract

The theme of fiscal dominance on monetary policy is an old issue. Basically, in an environment of high debt and high risk premium, inflation targeting does not work well. Higher interest rates lead to higher debt, a higher risk premium, a depreciation, and so, to a higher inflation. In this study, we analyze the influence of fiscal constraints on pursuing monetary policy from the perspective of the risk premium. We use the monthly data of the last three years of the Turkish economy. We obtain the feedback rules for the interest rates by minimizing the loss functions, which include inflation, output gap, and interest rate smoothing as the goal variables. According to the rule obtained under weak fiscal conditions, we observe the negative response of interest rate to inflation, which is the opposite of the rule obtained in absence of high risk premium and debt burden.