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Fiscal Constraints on Monetary Policy: How Debt Limits Monetary Effectiveness

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  • Bayer, Christian
  • Gong, Zheng
  • Kuester, Keith

Abstract

Monetary policy invariably leaves a fiscal footprint; not only whether but also when that footprint is eliminated is central to monetary transmission. We provide closed-form solutions for a New Keynesian model with government debt. Debt provides liquidity services. Debt, thus, affects the natural rate of interest. We show how the timing of fiscal adjustment shapes the effects of monetary tightening. As adjustment is deferred, outcomes become reminiscent of active fiscal policy, even if fiscal policy is known eventually to absorb the footprint: Even with finite fiscal delays, a rate hike can become inflationary, and potentially expansionary. The effect is found in data and quantitatively also in a richer quantitative HANK-OLG.

Suggested Citation

  • Bayer, Christian & Gong, Zheng & Kuester, Keith, 2026. "Fiscal Constraints on Monetary Policy: How Debt Limits Monetary Effectiveness," CEPR Discussion Papers 21995, Centre for Economic Policy Research.
    • Handle: RePEc:cpr:ceprdp:21995
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    File URL: https://cepr.org/publications/DP21995
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    Keywords

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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • 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; Treasury Policy
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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