LAUSR

This paper focuses on the question of what monetary and fiscal policy can do and should do in a “fiscal dominance” world. I first highlight that both “amplification” and “fiscal cushion” effects are always at work jointly in determining the evolution of inflation. I find the threshold of maturity of government bonds beyond which more aggressive monetary policy dampens inflation volatility is three quarters. In addition, I conduct welfare analysis to quantitatively evaluate the costs and benefits brought by long-term debt. My results show that the threshold of government debt maturity above which an aggressive monetary policy improves welfare is eight quarters. More importantly, I characterize optimal monetary and fiscal policy using simple and implementable rules. My results indicate an optimal monetary and fiscal combination calls for an aggressive response in both rules. Finally, I find that optimized simple monetary-fiscal rule is significantly welfare inferior to the Ramsey optimal policy.