Dormant Shocks and Fiscal Virtue
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We develop a theoretical framework to account for the observed instability of the link between inflation and fiscal imbalances across time and countries. Current policy makers' behavior influences agents' beliefs about the way debt will be stabilized. The standard policy mix consists of a virtuous fiscal authority that moves taxes in response to debt and a central bank that has full control over inflation. When policy makers deviate from this Virtuous regime, agents conduct Bayesian learning to infer the likely duration of the deviation. As agents observe more and more deviations, they become increasingly pessimistic about a prompt return to the Virtuous regime and inflation starts drifting in response to a fiscal imbalance. Shocks that were dormant under the Virtuous regime now start manifesting themselves. These changes are initially imperceptible, can unfold over decades, and accelerate as agents' beliefs deteriorate. Dormant shocks explain the run-up of US inflation and uncertainty in the '70s. The currently low long-term interest rates and inflation expectations might hide the true risk of inflation faced by the US economy.
We would like to thank the editors Jonathan Parker and Mike Woodford and our discussants Chris Sims and Bruce Preston for exceptionally thoughtful comments and great insights. We are grateful to Klaus Adam, Gadi Barlevy, Marco Bassetto, Jeff Campbell, Larry Christiano, John Cochrane, Marty Eichenbaum, Nir Jaimovich, Alejandro Justiniano, Eric Leeper, Guido Lorenzoni, Monika Piazzesi, Giorgio Primiceri, Juan Rubio-Ramirez, Martin Schneider, John Taylor, and all seminar participants at Stanford University, UCSD, Northwestern University, Columbia University, Chicago Fed, San Francisco Fed, Kansas City Fed, Indiana University, UNC Charlotte, UCLA, NBER Summer Institute, the Banque de France - Deutsche Bundesbank Macroeconomics and Finance Conference, SED, ESSIM Tarragona, Duke University, and Goethe University for useful comments and suggestions. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of Chicago or any other person associated with the Federal Reserve System. Francesco Bianchi gratefully acknowledges financial support from the National Science Foundation through grant SES-1227397. Correspondence: Francesco Bianchi, firstname.lastname@example.org, Leonardo Melosi, email@example.com.