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Inflation and the Fiscal Limit

Author

Listed:
  • Todd Walker

    (Indiana University)

  • Eric Leeper

    (Indiana University)

  • Troy Davig

    (Federal Reserve Bank of Kansas City)

Abstract

We use a rational expectations framework to assess the implications of rising debt in an environment with an unknown ‘fiscal limit.’ The fiscal limit is defined as the point where the government no longer has the ability to further expand its existing debt stock, so either fiscal or monetary policy must change to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as the unobserved fiscal limit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The upward bias that creeps into inflation expectations is more pronounced under high debt levels and high degrees of uncertainty surrounding the fiscal limit.

Suggested Citation

  • Todd Walker & Eric Leeper & Troy Davig, 2010. "Inflation and the Fiscal Limit," 2010 Meeting Papers 837, Society for Economic Dynamics.
    • Handle: RePEc:red:sed010:837
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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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