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Dormant Shocks and Fiscal Virtue

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  • Francesco Bianchi
  • Leonardo Melosi

Abstract

We develop a theoretical framework to account for the observed instability of the link between inflation and fiscal imbalances across time and countries. Current policy makers behavior influences agents' beliefs about the way debt will be stabilized. The standard policy mix consists of a virtuous fiscal authority that moves taxes in response to debt and a central bank that has full control over inflation. When policy makers deviate from this Virtuous regime, agents conduct Bayesian learning to infer the likely duration of the deviation. As agents observe more and more deviations, they become increasingly pessimistic about a prompt return to the Virtuous regime and inflation starts drifting in response to a fiscal imbalance. Shocks which were dormant under the Virtuous regime now start manifesting themselves. These changes are initially imperceptible, can unfold over decades, and accelerate as agents' beliefs deteriorate. Dormant shocks explain the run-up of US inflation and uncertainty in the 70s. The currently low long term interest rates and inflation expectations might hide the true risk of inflation faced by the US economy.

Suggested Citation

  • Francesco Bianchi & Leonardo Melosi, 2013. "Dormant Shocks and Fiscal Virtue," Working Papers 13-12, Duke University, Department of Economics.
  • Handle: RePEc:duk:dukeec:13-12
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    More about this item

    Keywords

    Fiscal Policy; Monetary Policy; Agents beliefs; Markov-switching models; Bayesian learning; Inflation;
    All these keywords.

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • 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

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