Inflation and the Fiscal Limit
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.
We thank Juergen von Hagen, Campbell Leith, Jim Nason, and participants at the European Economic Review conference for helpful comments. The views expressed herein are those of the authors and do not necessarily represent those of Barclays Capital, nor those of the National Bureau of Economic Research.
Davig, Troy & Leeper, Eric M. & Walker, Todd B., 2011. "Inflation and the fiscal limit," European Economic Review, Elsevier, vol. 55(1), pages 31-47, January. citation courtesy of