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We develop a optimal rules-based interpretation of the 'three pillars macroeconomic policy framework': a combination of a freely floating exchange rate, an explicit target for inflation, and a mechanism than ensures a stable government debt-GDP ratio around a specified long run. We show how such monetary-fiscal rules need to be adjusted to accommodate specific features of emerging market economies. The model takes the form of two-blocs, a DSGE emerging small open economy interacting with the rest of the world and features, in particular, financial frictions It is calibrated using Chile and US data. Alongside the optimal Ramsey policy benchmark, we model the three pillars as simple monetary and fiscal rules including and both domestic and CPI inflation targeting interest rate rules alongside a 'Structural Surplus Fiscal Rule' as followed recently in Chile. A comparison with a fixed exchange rate regime is made. We find that domestic inflation targeting is superior to partially or implicitly (through a CPI inflation target) or fully attempting to stabilizing the exchange rate. Financial frictions require fiscal policy to play a bigger role and lead to an increase in the costs associated with simple rules as opposed to the fully optimal policy.

Finance --- Business & Economics --- Money --- Monetary policy --- Fiscal policy --- Banks and Banking --- Macroeconomics --- Money and Monetary Policy --- Public Finance --- Fiscal Policy --- Macroeconomics: Consumption --- Saving --- Wealth --- Interest Rates: Determination, Term Structure, and Effects --- Monetary Systems --- Standards --- Regimes --- Government and the Monetary System --- Payment Systems --- Monetary economics --- Consumption --- Fiscal rules --- Zero lower bound --- Currencies --- Economics --- Interest rates --- Chile

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The initial government debt-to-GDP ratio and the government’s commitment play a pivotal role in determining the welfare-optimal speed of fiscal consolidation in the management of a debt crisis. Under commitment, for low or moderate initial government debt-to-GPD ratios, the optimal consolidation is very slow. A faster pace is optimal when the economy starts from a high level of public debt implying high sovereign risk premia, unless these are suppressed via a bailout by official creditors. Under discretion, the cost of not being able to commit is reflected into a quick consolidation of government debt. Simple monetary-fiscal rules with passive fiscal policy, designed for an environment with “normal shocks”, perform reasonably well in mimicking the Ramsey-optimal response to one-off government debt shocks. When the government can issue also long-term bonds–under commitment–the optimal debt consolidation pace is slower than in the case of short-term bonds only, and entails an increase in the ratio between long and short-term bonds.

Debts, Public. --- Monetary policy. --- Fiscal policy. --- Tax policy --- Taxation --- Economic policy --- Finance, Public --- Monetary management --- Currency boards --- Money supply --- Debts, Government --- Government debts --- National debts --- Public debt --- Public debts --- Sovereign debt --- Debt --- Bonds --- Deficit financing --- Government policy --- Financial Risk Management --- Investments: Bonds --- Public Finance --- Monetary Policy --- Fiscal Policy --- Crisis Management --- Debt Management --- Sovereign Debt --- National Government Expenditures and Related Policies: General --- General Financial Markets: General (includes Measurement and Data) --- Public finance & taxation --- Investment & securities --- Macroeconomics --- Finance --- Expenditure --- Fiscal policy --- Debt management --- Financial institutions --- Asset and liability management --- Debts, Public --- Expenditures, Public --- United States