Achieving a Soft Landing: The Role of Fiscal Policy

IMF Working Papers, March 1, 2008

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Paper utilizes an open-economy New Keynesian overlapping generations model to assess the extent to which fiscal policy, alongside an inflation-forecast-based monetary policy, could enhance macroeconomic stability in Colombia.
Model simulations indicate that:
- A stronger response of the fiscal balance to excess tax revenue would reduce the burden on the central bank of adjusting interest rates.
- Such a fiscal response would lessen the associated degree of exchange rate volatility.
- It would contribute to a more stable external current account balance.
- Fiscal policy can stabilize output and inflation in addition to the monetary policy framework.

Model type: open-economy New Keynesian overlapping generations model.
Monetary policy framework considered: inflation-forecast-based monetary policy.
Analysis assesses sensitivity of fiscal policy effectiveness to:
- The type of shock.
- The response of monetary policy.
- The length of fiscal policy implementation lags.

Strengthen fiscal balance responses to excess tax revenue to:
- Reduce central bank interest-rate adjustment needs.
- Lower exchange rate volatility.
- Stabilize the external current account.
Consider interactions between fiscal and monetary policy when designing stabilization strategies.
Account for implementation lags when evaluating potential stabilizing benefits of fiscal policy.

Success of fiscal policy in enhancing macroeconomic stability depends on:
- Type of shock affecting the economy.
- How monetary policy responds to shocks (inflation-forecast-based rule considered).
- Length of fiscal policy implementation lags.