Although central banks have recently taken unconventional policy actions to try to shore up macroeconomic and financial stability, little theory is available to assess the consequences of such measures. This paper offers a theoretical model with which such policies can be analyzed. In particular, the paper shows that in the absence of the fiscal authorities’ full backing of the central bank’s balance sheet, strange things can happen. For instance, an exit from quantitative easing could be inflationary and central banks cannot successfully unwind inflated balance sheets.
Therefore, the fiscal authorities’ full backing of the monetary authorities’ quasi-fiscal operations is a pre-condition for effective monetary policy.
Recently, central banks implemented unconventional operations by accumulating risky assets in an attempt to mitigate the financial turmoil that began in 2008 and the Euro zone fiscal crises. The operations altered the central banks’ balance sheet in both size and substance, and the magnitude of these operations was significant. These operations can be referred to as a
‘quasi-fiscal policy’ of central banks because they do not conform to traditional monetary policy, which is used to stabilize inflation by controlling the policy interest rate. Instead of being innate to central banks, most of these activities could be implemented by fiscal authorities. In this paper, a quasi-fiscal policy is defined as any policy action that affects the central banks’ balance sheets, with the exception of the traditional monetary policy mentioned above. For example, since credit easing operations alter the composition of the central banks’ asset accounts, they are considered quasi-fiscal policies. If losses are incurred from the central bank’s assets and the fiscal authorities decide not to compensate these losses, then the fiscal authorities’ decision is also a quasi-fiscal policy because it decreases the central banks’ capital account.
Some have worried that the quasi-fiscal policies of the central bank may undermine its independence and ability to stabilize inflation (Sims, 2003; and Goodfriend, 2011). In this regard, Goodfriend (2011) proposed accord principles between the central banks and fiscal authorities that will insulate the central banks from quasi-fiscal policy shocks. Also, an empirical study by Klüh and Stella (2008) showed that financially weak central banks were ineffective in stabilizing inflation. However, little economic theory is available to explain how and when the central banks’ quasi-fiscal policy affects inflation and imposes restriction on monetary policy. The issue can be particularly crucial for central banks without sound fiscal support, such as the European Central Bank. This paper proposes a simple dynamic stochastic general equilibrium (DSGE) model in order to address the following questions: (i) Do quasi-fiscal policies and the central banks’ balance sheets affect inflation? and (ii) Do the central banks’ balance sheets have implications for policy interactions between the central banks and fiscal authorities?
The model predicts that the central banks’ balance sheet shocks affect inflation through private agents’ (households’) portfolio adjustment when the fiscal authorities do not financially support central banks. That is, in that particular policy regime, the price level is determined by a ratio between the nominal and real value of the central bank’s net liability. For example, suppose that a central bank with a negative capital suffers additional losses from long-term bond holdings while the central bank tries to increase short-term interest rate in response to inflationary pressure. As the real value of holding the central bank’s net liability falls below the equilibrium with the negative return shock, then the private agent tries to decrease holdings of the central bank’s liability (nominal money balance) and increase consumption. In the end, the general price level increases, and the central bank passively increases nominal money supply in order to satisfy real money balance demand.
Paradoxically, the hike in the policy rate (deflationary monetary policy) induces inflation in this case. In other words, the central bank is confined to a situation where it cannot play an active role in stabilizing inflation. Since fiscal support of the central bank’s balance sheet precludes such type of equilibrium, therefore, the fiscal authority’s back-up is a pre-condition for effective monetary policy when the central bank is engaged in the other policy role such as maintaining financial stability.
Sargent and Wallace (1981), Leeper (1991) and Sims (1994) connected monetary and fiscal policy by showing that one policy may impose restrictions on the other policy, and that the two policies should interact in a coherent way in order to deliver a unique equilibrium. In this conventional approach to policy interaction, the budget constraints of the central banks and fiscal authorities are consolidated into a single equation. In other words, conventional models implicitly assume that the fiscal authorities acknowledge the central banks’ liabilities and assets as their own liabilities and assets, and that the central banks’ losses are automatically compensated by the fiscal authorities. Owing to these assumptions, in conventional models
the budget constraint of the central banks does not impose restrictions on the equilibrium.
However, questions can be raised about this conventional assumption. Stella and Lönnberg (2008) surveyed 135 central banks and discovered that laws did not always guarantee the fiscal authorities’ responsibility for the central banks’ liabilities, and that the fiscal authorities are not always prompt in recapitalizing the central banks. In this regard, this paper relaxes the conventional assumption by elaborating on the institutional details which state that the central banks’ flow budget constraint is separate from the fiscal authorities’ flow budget constraint. In addition, this paper’s public sector model includes the fiscal authorities transfer rule for recapitalizing the central banks, and the transfer rule is the key quasi-fiscal policy in the benchmark model.
Furthermore, this paper departs from conventional models by assuming that the real values of the central banks’ and fiscal authorities’ liabilities have finite upper bounds, which are the expected present values of their future earnings. Owing to this assumption, the peculiar equilibria, where the fiscal authorities and central banks can run a Ponzi scheme on each other and the real value of the central banks’ capital grows (or shrinks) infinitely, are excluded from this paper. By utilizing this assumption and the institutional details of the flow budget constraints, we show that the intertemporal equilibrium condition from the central banks’ budget constraint (the central banks’ net liability valuation formula) restrict equilibrium inflation in a certain policy regime.
In the abovementioned policy regime, quasi-fiscal policy is ‘active,’ while monetary and fiscal policies are ‘passive.’4 The active quasi-fiscal policy means that the fiscal authorities do not stabilize the central banks’ real capital and do not increase the fund transfer to the central banks when losses are incurred. As described in the previous example, monetary and fiscal policies are passively adjusted in order to satisfy the other equilibrium conditions, thus equilibrium inflation is uniquely determined by the central banks’ net liability valuation formula in this regime. In this regard, this paper is an extension of the Fiscal Theory of Price Level (FTPL) such as Leeper (1991). The model in this paper includes two intertemporal equilibrium conditions (from the public sector’s separated flow budget constraints) and three policy instruments (monetary, fiscal, and quasi-fiscal), whereas one intertemporal equilibrium condition (from the public sector’s consolidated flow budget constraint) and two policy instruments (monetary and fiscal) exist in the conventional FTPL.
A few studies have been completed that shed light on the effects of concerns over the central banks’ balance sheets. Jeanne and Svensson (2007) showed that if the central banks suffer losses when their capital falls under a fixed level, then the central banks’ commitment to escape from the liquidity trap is more credible. Sims (2003) showed that the central banks’ balance sheet concerns might undermine the central banks’ abilities to prevent inflation. Berriel and Bhattarai (2009) showed that the optimal monetary policy is significantly different when the central bank’s budget constraint is separate from the fiscal authorities’ budget constraint. Specifically, as the central banks place higher effective weight on inflation in the loss function, the variation in inflation decreases.
One of the differences between this paper and previous literature on the central banks’ balance sheets is that a new type of equilibrium exists even if the policy interest rate does not depend upon the status of the central banks’ balance sheets. For example, in Jeanne and Svensson (2007) and Berriel and Bhattarai (2009), the central banks’ loss function includes a deviation of the central banks’ real capital. In these cases, the central banks’ monetary policy behavior may be restricted by the balance sheet concerns. However, the monetary policy behavior in this paper follows a simple Taylor rule. In other words, the central bank, in this paper, will not generate seigniorage in response to its balance sheet concerns.
The remainder of this paper is organized as follows. In Section II, we build the model for the rational-expectations general equilibrium in exact nonlinear forms. In Section III, the equilibrium conditions are linearized around the deterministic steady state in order to derive analytic solutions. In addition, we explain the equilibrium in the active quasi-fiscal policy regime in this section. The benchmark model is extended to include the exit strategy in Section IV, and Section V concludes the paper.
World Bank. Author/Editor:Park, Seok Gil