Effects of trend inflation on monetary policy and fiscal policy shocks in Vietnam

Purpose – This paper analyzes variations in the effects of monetary and fiscal shocks on responses of macroeconomic variables, determinacy region, and welfare costs due to changes in trend inflation. Design/methodology/approach – The authors develop the New-Keynesian model, in which the central banks can employ either nominal interest rate (IR rule) or money supply (MS rule) to conduct monetary policies. They also use their capital and recurrent spending budgets to conduct fiscal policies. By using the simulated method of moment (SMM) for parameter estimation, the authors characterize Vietnam's economy during 1996Q1–2015Q1. Findings – The results report that consequences of monetary policy and fiscal policy shocks become more serious if there is a rise in trend inflation. Furthermore, the money supply might not be an effective instrument, and using the government budget for recurrent spending produces severe consequences in the high-trend inflation economy. Practical implications – This paper's findings are critical for economists and monetary and fiscal authorities in effectively designing both the monetary and fiscal policies in confronting the shift in the inflation targets. Originality/value – This is the first paper that examines the effects of trend inflation on the monetary and fiscal policy implementation in the case of Vietnam.