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Temporarily Unstable Government Debt and Inflation

  • Troy Davig
  • Eric M. Leeper

Many advanced economies are heading into an era of fiscal stress: populations are aging and governments have made substantially more promises of old-age benefits than they have made provisions to finance. This paper models the era of fiscal stress as stemming from relentlessly growing promised government transfers that initially are fully honored, being financed by new sales of government debt that bring forth higher future income taxes. As debt levels and tax rates rise, the population's tolerance for taxation declines and the probability of reaching the fiscal limit increases. At the limit a fixed tax rate is adopted, adjustments in taxes no longer stabilize debt, and some new stabilizing combination of policies must arise. We examine how, in the period before the fiscal limit, rapidly rising debt interacts with expectations of how and when policies will adjust. Temporarily explosive debt has no effect on inflation if households expect all adjustments to occur through entitlements reform, but if households believe it is possible that in the future monetary policy will shift from targeting inflation to stabilizing debt, then debt feeds directly into the path of inflation and monetary policy can no longer control inflation. News that reduces expected primary surpluses can bring future inflation into the present, well before the news shows up in fiscal measures.

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File URL: http://www.nber.org/papers/w16799.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16799.

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Date of creation: Feb 2011
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Publication status: published as Troy Davig & Eric M Leeper, 2011. "Temporarily Unstable Government Debt and Inflation," IMF Economic Review, Palgrave Macmillan, vol. 59(2), pages 233-270, June.
Handle: RePEc:nbr:nberwo:16799
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  1. Troy Davig & Eric M. Leeper & Todd B. Walker, 2010. ""Unfunded Liabilities" and Uncertain Fiscal Financing," NBER Working Papers 15782, National Bureau of Economic Research, Inc.
  2. Troy Davig, 2005. "Periodically expanding discounted debt: a threat to fiscal policy sustainability?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 20(7), pages 829-840.
  3. Ben S. Bernanke & Julio J. Rotemberg, 1997. "NBER Macroeconomics Annual 1997, Volume 12," NBER Books, National Bureau of Economic Research, Inc, number bern97-1, Abril.
  4. Willem H. Buiter, 2002. "The Fiscal Theory Of The Price Level: A Critique," Economic Journal, Royal Economic Society, vol. 112(481), pages 459-480, July.
  5. Hamilton, James D & Flavin, Marjorie A, 1986. "On the Limitations of Government Borrowing: A Framework for EmpiricalTesting," American Economic Review, American Economic Association, vol. 76(4), pages 808-19, September.
  6. Mathias Trabandt & Harald Uhlig, 2009. "How Far Are We From The Slippery Slope? The Laffer Curve Revisited," NBER Working Papers 15343, National Bureau of Economic Research, Inc.
  7. Eric M. Leeper, 2010. "Monetary science, fiscal alchemy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 361-434.
  8. Stefano Eusepi & Bruce Preston, 2012. "Debt, Policy Uncertainty, And Expectations Stabilization," Journal of the European Economic Association, European Economic Association, vol. 10(4), pages 860-886, 08.
  9. Davig, Troy & Leeper, Eric M. & Walker, Todd B., 2011. "Inflation and the fiscal limit," European Economic Review, Elsevier, vol. 55(1), pages 31-47, January.
  10. Bennett T. McCallum, . "Indeterminacy, Bubbles, and the Fiscal Theory of Price Level Determination," GSIA Working Papers 1998-19, Carnegie Mellon University, Tepper School of Business.
  11. Davig, Troy & Leeper, Eric M., 2009. "Monetary-Fiscal Policy Interactions and Fiscal Stimulus," CEPR Discussion Papers 7509, C.E.P.R. Discussion Papers.
  12. Troy Davig & Eric M. Leeper, 2011. "Temporarily Unstable Government Debt and Inflation," NBER Working Papers 16799, National Bureau of Economic Research, Inc.
  13. Troy Davig & Eric M. Leeper, 2005. "Fluctuating Macro Policies and the Fiscal Theory," NBER Working Papers 11212, National Bureau of Economic Research, Inc.
  14. Trabandt, Mathias & Uhlig, Harald, 2011. "The Laffer curve revisited," Journal of Monetary Economics, Elsevier, vol. 58(4), pages 305-327.
  15. 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.
  16. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Sticky price models of the business cycle: can the contract multiplier solve the persistence problem?," Staff Report 217, Federal Reserve Bank of Minneapolis.
  17. Ben S. Bernanke & Julio J. Rotemberg, 1997. "Editorial in "NBER Macroeconomics Annual 1997, Volume 12"," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 1-6 National Bureau of Economic Research, Inc.
  18. 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.
  19. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
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