Public Debt, Taylor Rules, and Inflation Dynamics in an Overlapping Generations Model

This chapter employs the discipline of the overlapping generations monetary framework originally developed by Marini and van der Ploeg (The Economic Journal, Vol. 98, September 1988, pp. 772–786) in order to study the dynamic consequences of fiscal policy regimes targeting real government liabilities relative to the size of the economy, via gradual adjustment rules, which interact with interest-rate policy regimes targeting inflation, via Taylor rules. The main result is that a fiscal easing enlarging the target stock of government liabilities causes inflation to increase both in the short run and in the long run, even under an aggressive interest-rate policy and an intertemporally balanced budgetary policy stance. Differently from the fiscal theory of the price level, fiscal regimes need not be “non-Ricardian”—i.e., disregarding the public solvency constraint—to reveal the debt–inflation relationship. The view that the rules-based approach to monetary policy is not sufficient to anchor inflation at the target rate without an appropriate commitment by the government over the long-run debt position and the pace of debt reduction—even under “Ricardian” fiscal regimes—has therefore additional analytical foundations. The chapter’s results suggest that inflation is neither only a monetary nor only a fiscal phenomenon. Rather, it appears to be a monetary–fiscal phenomenon.