Since Leeper's (1991, Journal of Monetary Economics 27, 129-147) seminal paper, an extensive literature has argued that if fiscal policy is passive, that is, 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 considers an optimizing framework in which the government can only finance public expenditures by levying distortionary taxes. It is shown that households' participation constraints and Laffer-type effects may 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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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number
15348.
Find related papers by JEL classification: H31 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Household E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management
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