DFG Project (No. 446166239)

"Fiscal sustainability and its implications for monetary policy"

In the aftermath of the financial crisis of 2007/2008 fiscal sustainability became a vital problem for nearly all economies. The need to implement sustainable policies is reflected in soaring government debt levels, the effects of unconventional monetary policies on central bank balance sheets and interdependencies of financial- and debt crises with the real economy. The New-Keynesian (NK) modeling framework plays a central role for monetary and fiscal policy and in the analysis of business cycles. However, the financial crisis highlighted some major weaknesses of the simple NK model, as it partially suggests paradox results and policy recommendations. These flaws highlight the need to develop new theories and models. A promising route giving more weight on the fiscal dimension of macroeconomics is the fiscal theory of the price level (FTPL), which has received renewed attention in the academic debates in recent years. By embedding FTPL in the NK modeling framework, many of the above weaknesses are resolved. Based on extensions to the continuous time NK-FTPL framework of Sims (2011) and Cochrane (2018), we plan to develop new solution strategies and policy recommendations. Under the premise of sustainable fiscal and monetary policy, a particular focus will be on the important questions regarding high levels of government debt, the consequences of austerity, the rise of central bank balance sheets due to the unconventional monetary policy measures and the role of risk premiums on government bonds in the emergence of sovereign defaults. Those strategies based on a new synthesis of monetary and fiscal policies, which ensure a sustainable effectiveness of their policy instruments, should help to alleviate the real consequences of future debt crises, or even avoid them entirely.

This project is intended to provide new insights to the following questions: How do soaring government debt levels impact the ability of policy makers to deal with future economic crises? What are the effects of (unconventional) monetary and fiscal interdependencies on the implementation of a sustainable monetary policy? What is the role of risk premia on government bonds in the emergence of sovereign default?