Project Paper - Session 4
"Fiscal Discipline/Government Debt Management and Monetary Policy" (Abstract of Discussion Paper 04-J-011)
Just as the stock market functions as a disciplinary mechanism for corporate management and activities, the government bond market administers discipline to the government's fiscal management. This paper examines the mechanism of fiscal discipline through financial markets. The major findings of the study are as follows. First of all, there are two channels through which market discipline is provided � government bond prices and the value of national currency. When a country's fiscal condition deteriorates, the prices of government bonds issued by the country fall, while at the same time prices of goods go up and the value of the national currency goes down. These changes in prices put pressure on the government to restore fiscal health. Secondly, in order to give full play to such market discipline, active involvement by the central bank is indispensable. When the government's fiscal health continues to deteriorate, the central bank must send out a warning to the government by raising the target for nominal short-term rates, an instrumental variable of monetary policy. However, thirdly, market discipline has limitations which stem from being based on the principle of relative evaluation. The situation that has been continuing since the summer of 2000 � rising prices of government bonds, falling prices of goods, and the appreciation of the yen � can be interpreted as manifestations of such limitations.
