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Regional Debt in Monetary Unions: Is it Inflationary?

  • Cooper, R.
  • Kempf, H.
  • Peled, D.

This paper studies the inflationary implications of interest bearing regional debt in a monetary union. Is this debt simply backed by future taxation with no inflationary consequences? Or will the circulation of region debt induce monetization by a central bank? We argue here that both outcomes can arise in equilibrium. In the model economy, there are multiple equilibria which reflect the perceptions of agents regarding the manner in which the debt obligations will be met. In one equilibrium, termed Ricardian, the future obligations are met with taxation by a regional government while in the other, termed Monetization, the central bank is induced to print money to finance the region's obligations. The multiplicity of equilibria reflects a commitment problem of the central bank. A key indicator of the selected equilibrium is the distribution of the holdings of the regional debt. We show that regional governments, anticipating central bank financing of their debt obligations, have an incentive to create excessively large deficits. We use the model to assess the impact of policy measures within a monetary union.

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Paper provided by Banque de France in its series Working papers with number 186.

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Length: 31 pages
Date of creation: 2007
Date of revision:
Handle: RePEc:bfr:banfra:186
Contact details of provider: Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS
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  1. Carlos E. Zarazaga, 1993. "Hyperinflations and moral hazard in the appropriation of seigniorage," Working Papers 93-26, Federal Reserve Bank of Philadelphia.
  2. Russell Cooper & Hubert Kempf & Dan Peled, 2008. "Is It Is Or Is It Ain'T My Obligation? Regional Debt In A Fiscal Federation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 49(4), pages 1469-1504, November.
  3. Fernando Broner & Alberto Martin & Jaume Ventura, 2006. "Sovereign Risk and Secondary Markets," NBER Working Papers 12783, National Bureau of Economic Research, Inc.
  4. Smith, Bruce D, 1994. "Efficiency and Determinacy of Equilibrium under Inflation Targeting," Economic Theory, Springer, vol. 4(3), pages 327-44.
  5. V. V. Chari & Patrick J. Kehoe, 2002. "Time Consistency and Free-Riding in a Monetary Union," NBER Working Papers 9370, National Bureau of Economic Research, Inc.
  6. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  7. Beetsma, Roel & Uhlig, Harald, 1999. "An Analysis of the Stability and Growth Pact," Economic Journal, Royal Economic Society, vol. 109(458), pages 546-71, October.
  8. Russell W. Cooper & Hubert Kempf, 2001. "Dollarization and the conquest of hyperinflation in divided societies," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 3-12.
  9. V. V. Chari & Patrick J. Kehoe, 1998. "On the need for fiscal constraints in a monetary union," Working Papers 589, Federal Reserve Bank of Minneapolis.
  10. Russell Cooper & Hubert Kempf, 2004. "Overturning Mundell: Fiscal Policy in a Monetary Union," Review of Economic Studies, Oxford University Press, vol. 71(2), pages 371-396.
  11. Dixit, Avinash & Lambertini, Luisa, 2003. "Symbiosis of monetary and fiscal policies in a monetary union," Journal of International Economics, Elsevier, vol. 60(2), pages 235-247, August.
  12. Russell Cooper & Hubert Kempf, 2004. "Overturning Mundell : Fiscal policy in a monetary union," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00266420, HAL.
  13. Velasco, Andres, 2000. "Debts and deficits with fragmented fiscal policymaking," Journal of Public Economics, Elsevier, vol. 76(1), pages 105-125, April.
  14. Aizenman, Joshua, 1992. "Competitive Externalities and the Optimal Seigniorage," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(1), pages 61-71, February.
  15. Beetsma, Roel M.W.J. & Debrun, Xavier, 2007. "The new stability and growth pact: A first assessment," European Economic Review, Elsevier, vol. 51(2), pages 453-477, February.
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