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Is the Quantity of Government Debt a Constraint for Monetary Policy?

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  • Srobona Mitra
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    Abstract

    This paper derives an interest rate rule for monetary policy in which the interest rate response of the central bank toward an increase in expected inflation falls as debts increase beyond a certain threshold level. A debt-constrained interest rate rule and the threshold level of debt are jointly estimated for Canada during the first decade of its inflation targeting regime of the 1990s. There are three main findings of this paper. First, a high government debt could constrain monetary policy if government spending-rather than taxes-is expected to adjust in future in line with debt service costs. The ''constraint'' operates through an altered policy transmission mechanism through changes in the IS curve. Second, the effects of the debt-constraint on monetary policy are quite different during booms and recessions. Third, empirical estimates show that Canadian monetary policy might have been constrained by a high government debt-GDP ratio during the 1990s. Policy was less loose than what inflation indicators called for.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/62.

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    Length: 25
    Date of creation: 01 Mar 2007
    Date of revision:
    Handle: RePEc:imf:imfwpa:07/62

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    Keywords: Public debt; Interest rates; inflation; monetary policy; central bank; inflation rate; real interest rate; inflation targeting; monetary authorities; inflation-targeting; monetary policy rules; inflation targeting regime; nominal interest rate; monetary economics; monetary policy regime; price level; nominal interest rates; real interest rates; price stability; monetary financing; monetary fund; monetary conditions; monetary policy rule; monetary policy transmission mechanism; rational expectations; money growth; inflation rates; monetary system; long-term interest rates; rate of inflation; real value; inflation target; monetary policy instrument; monetary authority; macroeconomic stability; monetary policy objectives; independent central bank; monetary policy reaction function; increase in inflation; real rates; real output; monetary theory; monetary systems; inflation equation; discretionary monetary policy; monetary transmission; monetary policy implications;

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    References

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    1. Eric M. Leeper, 1989. "Policy rules, information and fiscal effects in a "Ricardian" model," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 360, Board of Governors of the Federal Reserve System (U.S.).
    2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1750, C.E.P.R. Discussion Papers.
    3. Ardagna, Silvia & Caselli, Francesco & Lane, Timothy, 2004. "Fiscal discipline and the cost of public dept service: some estiames for OECD countries," Working Paper Series, European Central Bank 0411, European Central Bank.
    4. Ardagna, Silvia & Caselli, Francesco & Lane, Timothy, 2004. "Fiscal Discipline and the Cost of Public Debt Service: Some Estimates for OECD Countries," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4661, C.E.P.R. Discussion Papers.
    5. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
    6. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy Rules for Inflation Targeting," NBER Working Papers 6512, National Bureau of Economic Research, Inc.
    7. Andrew G. Haldane & Nicoletta Batini, 1998. "Forward-Looking Rules for Monetary Policy," NBER Working Papers 6543, National Bureau of Economic Research, Inc.
    8. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
    9. 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.
    10. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Fall.
    11. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, Econometric Society, vol. 48(5), pages 1305-11, July.
    12. 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.
    13. Frederic S. Mishkin & Adam S. Posen, 1997. "Inflation targeting: lessons from four countries," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Aug, pages 9-110.
    14. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, Springer, vol. 4(3), pages 381-99.
    15. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
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    Cited by:
    1. Sven Jari Stehn & David Vines, 2008. "Strategic Interactions Between An Independent Central Bank and a Myopic Government with Government Debt," IMF Working Papers 08/164, International Monetary Fund.
    2. Svan Jari Stehn & David Vines, 2007. "Debt Stabilisation Bias And The Taylor Principle: Optimal Policy In A New Keynesian Model With Government Debt And Inflation Persistence," CAMA Working Papers 2007-22, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    3. Stehn, Sven Jari & Vines, David, 2008. "Debt Stabilisation Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6696, C.E.P.R. Discussion Papers.

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