Government expenditure shocks and inflation: A new fiscal policy rule with monetaryand fiscal interactions

Working Paper 902

Abstract

This paper introduces a new fiscal policy rule and examines how government expenditure shocks affect price stability with monetary and fiscal interactions. It finds that recent global inflation trends align with the principles of the fiscal theory of price level. Comparing this proposed rule to the LL rule from Leeper and Leith (2016), the new rule is more effective in reducing the impact of government shocks on inflation and the real economy. It also enhances debt stabilization without sacrificing price stability. Under Regime F, the new rule outperforms the LL rule in both price stability and debt stabilization. Both rules significantly reduce volatility in these areas under Regime M. The proposed rule also enhances social welfare, especially under Regime F. When bonds are long term, the proposed rule outperforms the baseline model with one-period bonds in attenuating the effects of government expenditure shocks on business cycle fluctuations.