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Control of the Public Debt: A Requirement for Price Stability?

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  • Michael Woodford

Abstract

The paper considers the role of limits upon the permissible growth of public debt, like those stipulated in the Maastricht treaty, in making price stability possible. It is shown that a certain type of fiscal instability, namely variations in the present value of current and future primary government budgets, necessarily results in price level instability, in the sense that there exists no possible monetary policy that results in an equilibrium with stable prices. In the presence of sluggish price adjustment, the fiscal shocks disturb real output and real interest rates as well. On the other hand, shocks of this kind can be eliminated by a Maastricht-type limit on the value of the public debt. In the presence of the debt limit (and under assumptions of frictionless financial markets, etc.), Ricardian equivalence holds, and fiscal shocks have no effects upon real or nominal variables. Furthermore, an appropriate monetary policy rule can ensure price stability even in the face of other kinds of real shocks. Thus the debt limit serves as a precondition for the common central bank in a monetary union to be charged with responsibility for maintaining a stable value for the common currency.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5684.

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Date of creation: Jul 1996
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Publication status: published as The Debt Burden and Monetary Policy, Calvo, G. and M. King, eds., London: MacMillan, 1997.
Handle: RePEc:nbr:nberwo:5684

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  1. Maurice Obstfeld & Kenneth Rogoff, 1996. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
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  15. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, vol. 4(3), pages 345-80.
  16. Rao Aiyagari, S. & Gertler, Mark, 1985. "The backing of government bonds and monetarism," Journal of Monetary Economics, Elsevier, vol. 16(1), pages 19-44, July.
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