Fiscal–Monetary Interactions with Structural Distortions in Developing Economies

This paper develops a novel theoretical framework for monetary policy in developing economies characterized by multiple structural distortions. We construct a multisector general equilibrium model featuring formal and informal sectors, public enterprises, subsidized essential goods, and imperfect financial intermediation. Our key innovation is the introduction of a "Dynamic Policy Coordination Index" that explicitly models the strategic interactions between fiscal and monetary authorities under weak institutional environments. The framework yields a new class of monetary rules that optimally respond to distortionary subsidies, informality-driven inflation dynamics, and external vulnerability. Mathematical analysis and numerical simulations demonstrate that our approach outperforms conventional policy rules by simultaneously addressing inflation-exchange rate trade-offs while creating a path toward reduced fiscal dominance. The model provides a rigorous theoretical foundation for practical implementation in economies with high inflation, overvalued exchange rates, significant informality, and distortionary subsidies. JEL Classification: E52, E58, H50, O17