TY  - JOUR
AU  - Davig,Troy
AU  - Leeper,Eric M.
AU  - Walker,Todd B.
TI  - Inflation and the Fiscal Limit
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 16495
PY  - 2010
Y2  - October 2010
UR  - http://www.nber.org/papers/w16495
L1  - http://www.nber.org/papers/w16495.pdf
N1  - Author contact info:
Troy Davig
Research Department
Federal Reserve Bank of Kansas City
Kansas City, MO 64198
E-Mail: troy.davig@kc.frb.org

Eric M. Leeper
Department of Economics
304 Wylie Hall
Indiana University
Bloomington, IN  47405
Tel: 812/855-9157
Fax: NA
E-Mail: eleeper@indiana.edu

Todd B. Walker
Department of Economics
105 Wylie Hall
Indiana University
Bloomington, IN  47405
E-Mail: walkertb@indiana.edu
AB  - We use a rational expectations framework to assess the implications of rising debt in an environment with a "fiscal limit." The fiscal limit is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes, so either an adjustment to fiscal spending or monetary policy must occur to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as over the timing of when the fiscal limit is hit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The distribution of outcomes for the path of future inflation has a fat right tail, revealing that only a small set of outcomes imply dire inflationary scenarios. Avoiding these scenarios, however, requires the fiscal authority to renege on some share of future promised transfers.
ER  -