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Public Debt, Distortionary Taxation, and Monetary Policy

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Since Leeper’s (1991, Journal of Monetary Economics 27, 129-147) seminal paper, an extensive literature has argued that if fiscal policy is passive, i.e., guarantees public debt stabilization irrespectively of the inflation path, monetary policy can independently be committed to inflation targeting. This can be pursued by following the Taylor principle, i.e., responding to upward perturbations in inflation with a more than one-for-one increase in the nominal interest rate. This paper analyzes an optimizing framework in which the government can only finance public expenditures by levying distortionary taxes. It is demonstrated that households’ market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate.

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  • Alessandro Piergallini & Giorgio Rodano, 2012. "Public Debt, Distortionary Taxation, and Monetary Policy," CEIS Research Paper 220, Tor Vergata University, CEIS, revised 07 Feb 2012.
  • Handle: RePEc:rtv:ceisrp:220
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    1. Jean-Pascal Bénassy, 2008. "Money, Interest, and Policy: Dynamic General Equilibrium in a Non-Ricardian World," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262524937, December.
    2. Rochelle M. Edge & Jeremy B. Rudd, 2002. "Taxation and the Taylor principle," Finance and Economics Discussion Series 2002-51, Board of Governors of the Federal Reserve System (U.S.).
    3. 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.
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    8. Leith, Campbell & von Thadden, Leopold, 2008. "Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers," Journal of Economic Theory, Elsevier, vol. 140(1), pages 279-313, May.
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    Cited by:

    1. Alfred Greiner, 2015. "Fiscal and Monetary Policy in a Basic Endogenous Growth Model," Computational Economics, Springer;Society for Computational Economics, vol. 45(2), pages 285-301, February.
    2. Cochrane, John H., 2011. "Understanding policy in the great recession: Some unpleasant fiscal arithmetic," European Economic Review, Elsevier, vol. 55(1), pages 2-30, January.
    3. Sergey Pekarski, 2017. "Tight Money and the Sustainability of Public Debt," International Journal of Central Banking, International Journal of Central Banking, vol. 13(1), pages 191-223, February.

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    More about this item

    Keywords

    Public Debt; Distortionary Taxation; Monetary and Fiscal Policy Rules.;
    All these keywords.

    JEL classification:

    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • H31 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Household
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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