Public debt, discretionary policy, and inflation persistence

We describe a simple mechanism that generates inflation persistence in a standard sticky-price model of optimal fiscal and monetary policy. Key to this mechanism is that policies are decided under discretion. The government's discretionary incentive to erode the real value of nominal public debt by means of surprise inflation renders inflation expectations and, in further consequence, equilibrium inflation rates highly correlated with the stock of public debt. Debt, in turn, is highly persistent to allow for tax-smoothing in the face of disturbances and, due to the aforementioned correlation, this persistence carries over to inflation. Our analysis shows a non-monotonic effect of nominal rigidities on inflation persistence and reveals further important differences between optimal policies under discretion versus commitment. Most notably, government debt under discretion does not display the near random walk property familiar from the Ramsey literature.