Fiscal Inaction as Monetary Support

How does the fiscal framework affect the central bank's ability to stabilize output and inflation? The textbook answer, which assumes Ricardian households, recommends that fiscal adjustment should be fast enough to allow for monetary dominance. We instead argue that, with non-Ricardian households, the central bank may indeed welcome slow, or even no, fiscal adjustment. On the demand side, slow fiscal adjustment helps stabilize aggregate spending; on the supply side, it eases tax distortions, improving the output-inflation trade off. And while the first channel favors slow fiscal adjustment only when the business cycle is dominated by demand shocks, the second channel extends this preference to supply shocks. A quantitative exercise affirms our lessons in the U.S. context, with the central bank preferring virtually no fiscal adjustment over the business cycle.