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Is the Quantity of Government Debt a Constraint for Monetary Policy?

  • Srobona Mitra
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    This paper derives an interest rate rule for monetary policy in which the interest rate response of the central bank toward an increase in expected inflation falls as debts increase beyond a certain threshold level. A debt-constrained interest rate rule and the threshold level of debt are jointly estimated for Canada during the first decade of its inflation targeting regime of the 1990s. There are three main findings of this paper. First, a high government debt could constrain monetary policy if government spending-rather than taxes-is expected to adjust in future in line with debt service costs. The 'constraint' operates through an altered policy transmission mechanism through changes in the IS curve. Second, the effects of the debt-constraint on monetary policy are quite different during booms and recessions. Third, empirical estimates show that Canadian monetary policy might have been constrained by a high government debt-GDP ratio during the 1990s. Policy was less loose than what inflation indicators called for.

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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/62.

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    Length: 25
    Date of creation: 01 Mar 2007
    Date of revision:
    Handle: RePEc:imf:imfwpa:07/62
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    1. Rudebusch, G.D. & Svensson, L.E.O., 1998. "Policy Rules for Inflation Targeting," Papers 637, Stockholm - International Economic Studies.
    2. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1998. "Monetary policy rules in practice Some international evidence," European Economic Review, Elsevier, vol. 42(6), pages 1033-1067, June.
    3. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
    4. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, vol. 4(3), pages 381-99.
    5. Ardagna Silvia & Caselli Francesco & Lane Timothy, 2007. "Fiscal Discipline and the Cost of Public Debt Service: Some Estimates for OECD Countries," The B.E. Journal of Macroeconomics, De Gruyter, vol. 7(1), pages 1-35, August.
    6. Frederic S. Mishkin & Adam S. Posen, 1997. "Inflation targeting: lessons from four countries," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 9-110.
    7. Eric M. Leeper, 1989. "Policy rules, information and fiscal effects in a "Ricardian" model," International Finance Discussion Papers 360, Board of Governors of the Federal Reserve System (U.S.).
    8. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
    9. Nicoletta Batini & Andrew Haldane, 1999. "Forward-Looking Rules for Monetary Policy," NBER Chapters, in: Monetary Policy Rules, pages 157-202 National Bureau of Economic Research, Inc.
    10. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
    11. Ardagna, Silvia & Caselli, Francesco & Lane, Timothy, 2004. "Fiscal discipline and the cost of public dept service: some estiames for OECD countries," Working Paper Series 0411, European Central Bank.
    12. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
    13. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
    14. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    15. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
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