Navigating by Falling Stars: Monetary Policy with Fiscally Driven Natural Rates

Abstract:
We study the monetary-fiscal interaction in a heterogeneous-agent New Keynesian model with a fiscal block. Due to household heterogeneity, the stock of public debt affects the natural interest rate, prompting the central bank to adjust its monetary policy rule in response to the fiscal stance, ensuring that inflation remains at its target. There is, however, a minimum level of debt below which the steady-state inflation deviates from its target due to the zero lower bound on nominal rates. We analyze the response to a debt-financed fiscal expansion and quantify the impact of different timings in adapting the monetary policy rule, as well as the performance of alternative monetary policy rules that do not require an assessment of the natural rates. We validate our findings with a series of empirical estimates

JEL codes: E32, E58, E63. Keywords: HANK models, natural rates, fiscal shocks.