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The Monetary Financing of a Large Fiscal Shock

Author

Listed:
  • Pedro Teles
  • Oreste Tristani

Abstract

Motivated by the surge in debt levels through the pandemic crisis, we revisit the issue of the optimal financing of public debt. In contrast with the existing literature, we find that the optimal response of inflation to a large increase in debt levels is a gradual but significant and long-lasting rise in inflation. The difference in our results is due to a different assumption on the source of nominal rigidities. While the literature has focused on sticky prices, of either the Calvo or Rotemberg type, we consider sticky plans as in the sticky information set up of Mankiw and Reis (2002). A crucial feature of our results is that a significant inflation response is desirable only if the maturity of debt is (realistically) long. In a calibrated example, we show that QE policies, by reducing the maturity of the debt held by the private sector, may lead to an optimally higher response of inflation.

Suggested Citation

  • Pedro Teles & Oreste Tristani, 2024. "The Monetary Financing of a Large Fiscal Shock," Working Papers w202403, Banco de Portugal, Economics and Research Department.
    • Handle: RePEc:ptu:wpaper:w202403
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    File URL: https://www.bportugal.pt/sites/default/files/documents/2024-07/WP202403.pdf
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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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