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Public Debt, Distortionary Taxation, and Monetary Policy

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  • Piergallini Alessandro
  • Rodano Giorgio

Abstract

Since Leeper's (1991, Journal of Monetary Economics, 27, pp. 129-147) seminal paper, an extensive literature has argued that if fiscal policy is passive, i.e., guarantees public debt stabilization irrespectively of the inflation path, monetary policy can independently be committed to inflation targeting. This can be pursued by following the Taylor principle, i.e., responding to upward perturbations in inflation with a more than one-for-one increase in the nominal interest rate. This paper analyzes an optimizing framework in which the government can only finance public expenditures by levying distortionary taxes. It is demonstrated that households' market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady-state by following the Taylor principle, monetary policy must target a higher inflation rate.

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Bibliographic Info

Article provided by Società editrice il Mulino in its journal Rivista italiana degli economisti.

Volume (Year): (2012)
Issue (Month): 2 ()
Pages: 225-248

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Handle: RePEc:mul:jqat1f:doi:10.1427/37495:y:2012:i:2:p:225-248

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Keywords: Public Debt; Distortionary Taxation; Monetary and Fiscal Policy Rules;

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References

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  1. Stephanie Schmitt-Grohe & Martin Uribe, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," NBER Working Papers 10253, National Bureau of Economic Research, Inc.
  2. Leith, Campbell & von Thadden, Leopold, 2006. "Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers," Working Paper Series, European Central Bank 0649, European Central Bank.
  3. Linnemann, Ludger, 2006. "Interest rate policy, debt, and indeterminacy with distortionary taxation," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 30(3), pages 487-510, March.
  4. John H. Cochrane, 2010. "Understanding Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic," NBER Working Papers 16087, National Bureau of Economic Research, Inc.
  5. Stephanie Schmitt-Grohe & Martin Uribe, 1995. "Balanced-budget rules, distortionary taxes, and aggregate instability," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 95-44, Board of Governors of the Federal Reserve System (U.S.).
  6. Troy Davig & Eric M. Leeper & Todd B. Walker, 2010. "Inflation and the Fiscal Limit," NBER Working Papers 16495, National Bureau of Economic Research, Inc.
  7. Michael Woodford, 1995. "Price Level Determinacy Without Control of a Monetary Aggregate," NBER Working Papers 5204, National Bureau of Economic Research, Inc.
  8. Cochrane, John H., 2005. "Money as stock," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(3), pages 501-528, April.
  9. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Fall.
  10. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, Springer, vol. 4(3), pages 345-80.
  11. Edge, Rochelle M. & Rudd, Jeremy B., 2007. "Taxation and the Taylor principle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(8), pages 2554-2567, November.
  12. Eric Leeper & Tack Yun, 2006. "Monetary-fiscal policy interactions and the price level:Background and beyond," International Tax and Public Finance, Springer, Springer, vol. 13(4), pages 373-409, August.
  13. Rochelle M. Edge & Jeremy B. Rudd, 2002. "Taxation and the Taylor principle," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2002-51, Board of Governors of the Federal Reserve System (U.S.).
  14. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
  15. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 27(1), pages 129-147, February.
  16. Jean-Pascal Bénassy, 2008. "Money, Interest, and Policy: Dynamic General Equilibrium in a Non-Ricardian World," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262524937, December.
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Cited by:
  1. John H. Cochrane, 2010. "Understanding Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic," NBER Working Papers 16087, National Bureau of Economic Research, Inc.

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