Debt Maturity, Term Premia, and Fiscal Inflation

The maturity of government debt affects inflation when bond-market arbitrage is limited. We develop a tractable model in which risk-averse arbitrageurs absorb duration risk, generating a term premium that rises with the supply of long-term debt. Lengthening maturity therefore raises the return on government debt relative to the policy rate. We show analytically that the resulting inflation dynamics depend on the monetary–fiscal regime. Under monetary dominance, inflation falls at every horizon despite monetary easing. Under fiscal dominance, inflation falls on impact but later turns positive, leaving the price level permanently higher. Lower bond prices require the initial deflation to maintain fiscal solvency, while higher borrowing costs eventually require inflation. In a calibrated New Keynesian model, a persistent lengthening of debt duration by one month raises the term premium by 17 basis points, lowers inflation by almost 0.2 percentage points, and contracts output under both regimes. Inflation takes around five years to turn positive under fiscal dominance.