Fiscal Dominance and Global Determinacy

Abstract

The existing literature on monetary-fiscal policy interactions emphasizes that an active monetary/passive fiscal policy regime causes global indeterminacy of equilibrium, supporting liquidity traps and self-fulfilling hyperinflations as possible equilibrium outcomes. In a nonlinear New Keynesian model with costly price adjustment, I show that an analogous critique, with different global macroeconomic dynamics, extends to a passive monetary/active fiscal policy regime whenever the fiscal response to government liabilities is below the steady-state real interest rate but positive. In this case, although the equilibrium is locally unique according to the Blanchard-Kahn conditions, there exist multiple inflation paths originating around the saddle path that converge asymptotically to the central bank's target rate while satisfying the private sector's transversality condition. I demonstrate that global determinacy instead requires a pure regime of fiscal dominance, with primary surpluses set independently of the real value of government liabilities. Only then are all nonlinear off-saddle trajectories ruled out as equilibria, for they violate the private sector's transversality condition or its no-Ponzi game condition, or imply an infeasible allocation. The transversality condition coincides with the government debt valuation equation, in which primary surpluses are discounted at the endogenous real interest rate, and pins down a unique initial jump in inflation onto the saddle path, leading to the unique steady state. The results imply that, when globally determinate, inflation is a fiscal phenomenon, shaped by the central bank's interest-rate policy.