Working Paper: CEPR ID: DP17407
Authors: Jean Barthélemy; Eric Mengus; Guillaume Plantin
Abstract: This paper studies a political-economy model in which the price level is the outcome of dynamic strategic interactions between a fiscal authority, a monetary authority, and investors in government bonds and reserves. The 'unpleasant monetarist arithmetic', whereby aggressive fiscal expansion forces the monetary authority to chicken out and to lose control of inflation, occurs only if the public sector lacks fiscal space, in the sense that public debt along the optimal fiscal path gets sufficiently close to the threshold above which the fiscal authority would find defaultoptimal. Otherwise, monetary dominance prevails even though the central bank has neither commitment power nor fiscal backing.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Aggressive fiscal expansion (E62) | Loss of control over inflation (E31) |
| Public debt approaches threshold for default (H63) | Push for inflationary policies (E64) |
| Inability to commit to sustainable fiscal path (H69) | Inflation outcomes (E31) |
| Sufficient fiscal space (E62) | Monetary dominance (E42) |
| Central bank actions aimed at price level control (E52) | Mitigation of risks of fiscal dominance (E63) |
| Game of chicken (C72) | Impact on monetary authority's behavior (E49) |
| Central bank tools to prevent fiscal dominance (E52) | Costs of fiscal dominance (H39) |