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Temporarily Unstable Government Debt and Inflation

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  • Troy Davig
  • Eric M. Leeper

Abstract

Many advanced economies are heading into an era of fiscal stress: populations are aging and governments have made substantially more promises of old-age benefits than they have made provisions to finance. This paper models the era of fiscal stress as stemming from relentlessly growing promised government transfers that initially are fully honored, being financed by new sales of government debt that bring forth higher future income taxes. As debt levels and tax rates rise, the population's tolerance for taxation declines and the probability of reaching the fiscal limit increases. At the limit a fixed tax rate is adopted, adjustments in taxes no longer stabilize debt, and some new stabilizing combination of policies must arise. We examine how, in the period before the fiscal limit, rapidly rising debt interacts with expectations of how and when policies will adjust. Temporarily explosive debt has no effect on inflation if households expect all adjustments to occur through entitlements reform, but if households believe it is possible that in the future monetary policy will shift from targeting inflation to stabilizing debt, then debt feeds directly into the path of inflation and monetary policy can no longer control inflation. News that reduces expected primary surpluses can bring future inflation into the present, well before the news shows up in fiscal measures.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16799.

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Date of creation: Feb 2011
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Publication status: published as Troy Davig & Eric M Leeper, 2011. "Temporarily Unstable Government Debt and Inflation," IMF Economic Review, Palgrave Macmillan, vol. 59(2), pages 233-270, June.
Handle: RePEc:nbr:nberwo:16799

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  1. Hamilton, James D & Flavin, Marjorie A, 1986. "On the Limitations of Government Borrowing: A Framework for EmpiricalTesting," American Economic Review, American Economic Association, American Economic Association, vol. 76(4), pages 808-19, September.
  2. Troy Davig & Eric M. Leeper & Todd B. Walker, 2010. ""Unfunded Liabilities" and Uncertain Fiscal Financing," NBER Working Papers 15782, National Bureau of Economic Research, Inc.
  3. Troy Davig, 2005. "Periodically expanding discounted debt: a threat to fiscal policy sustainability?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 20(7), pages 829-840.
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  9. Troy Davig & Eric M Leeper, 2011. "Temporarily Unstable Government Debt and Inflation," IMF Economic Review, Palgrave Macmillan, Palgrave Macmillan, vol. 59(2), pages 233-270, June.
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Cited by:
  1. Betty Daniel & Christos Shiamptanis, 2008. "Fiscal Risk in a Monetary Union," Discussion Papers, University at Albany, SUNY, Department of Economics 08-12, University at Albany, SUNY, Department of Economics.
  2. Troy Davig & Eric M Leeper, 2011. "Temporarily Unstable Government Debt and Inflation," IMF Economic Review, Palgrave Macmillan, Palgrave Macmillan, vol. 59(2), pages 233-270, June.
  3. Daniel, Betty C. & Shiamptanis, Christos, 2013. "Pushing the limit? Fiscal policy in the European Monetary Union," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 37(11), pages 2307-2321.
  4. Christos Shiamptanis, 2014. "Risk Assessment Under A Nonlinear Fiscal Policy Rule," LCERPA Working Papers, Laurier Centre for Economic Research and Policy Analysis lm0063, Laurier Centre for Economic Research and Policy Analysis, revised Jun 2014.
  5. Richard W. Evans & Laurence J. Kotlikoff & Kerk L. Phillips, 2012. "Game Over: Simulating Unsustainable Fiscal Policy," NBER Chapters, National Bureau of Economic Research, Inc, in: Fiscal Policy after the Financial Crisis, pages 177-202 National Bureau of Economic Research, Inc.
  6. Gliksberg, Baruch, 2012. "Monetary Policy and Fiscal Limits with No-Default," Working Papers, University of Haifa, Department of Economics WP2012/6, University of Haifa, Department of Economics, revised 19 May 2013.
  7. Libich, Jan & Nguyen, Dat & Stehlik, Petr, 2014. "Monetary Exit and Fiscal Spillovers," MPRA Paper 57266, University Library of Munich, Germany.

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