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Gambling to Preserve Price (and Fiscal) Stability

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  • Corsetti, Giancarlo
  • Mackowiak, Bartosz

Abstract

We study a model in which policy aims at aggregate price stability. A fiscal imbalance materializes that, if uncorrected, must cause inflation, but the imbalance may get corrected in the future with some probability. By maintaining price stability in the near term, monetary policy can buy time for a correction to take place. The policy gamble may succeed, preserving price and fiscal stability, or fail, leading to a delayed, possibly large jump in the price level. The resulting dynamics resemble the models of a currency crisis following Krugman (1979) and Obstfeld (1986). Like in Obstfeld’s work, multiple equilibria arise naturally: whether or not price stability is preserved may depend on private agents’ expectations. The model can be reinterpreted as a model of partial default on public debt, in which case it is reminiscent of Calvo (1988).

Suggested Citation

  • Corsetti, Giancarlo & Mackowiak, Bartosz, 2022. "Gambling to Preserve Price (and Fiscal) Stability," CEPR Discussion Papers 17588, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:17588
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    More about this item

    Keywords

    Multiple equilibria; Self-fulfilling beliefs; Fiscal theory of the price level; Inflation expectations; Currency crisis;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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