| Abstract |
This paper studies optimal monetary and fiscal policy when the Treasury is unable to provide fiscal backing to the central bank. The Treasury levies taxes and issues bonds. The central bank issues reserves for its liquidity value and pays interest expenses on reserves, but transfers from the Treasury are constrained. This lack of fiscal backing has implications for monetary and fiscal policy. On the monetary side, the central bank tolerates higher inflation in response to negative productivity shocks, because the central bank optimally chooses a lower nominal interest rate. On the fiscal side, the volatility of the distortionary tax on sales is higher over the business cycle, because the central bank retains its earnings and transfers less to the Treasury. Moreover, this difference due to the lack of fiscal backing is exacerbated by the level of reserves and the size of the shock. |