Working Paper: NBER ID: w23605
Authors: Francesco Bianchi; Leonardo Melosi
Abstract: What happens if the government's willingness to stabilize a large stock of debt is waning, while the central bank is adamant about preventing a rise in inflation? The large fiscal imbalance brings about inflationary pressures, triggering a monetary tightening, further debt accumulation, and additional inflationary pressure. Thus, the economy will go through a spiral of higher inflation, output contraction, and further debt accumulation. A coordinated commitment to inflate away the portion of debt resulting from a large recession leads to better macroeconomic outcomes by separating the issue of long-run fiscal sustainability from the need for short-run fiscal stabilization. This strategy can also be used to rule out episodes in which the central bank becomes constrained by the zero lower bound.
Keywords: Monetary Policy; Fiscal Policy; Coordination; Inflation; Debt
JEL Codes: D83; E31; E52; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lack of coordination between fiscal and monetary policies (E61) | Higher inflation (E31) |
| Higher inflation (E31) | Increased inflation expectations (E31) |
| Increased inflation expectations (E31) | Higher real interest rates (E43) |
| Higher real interest rates (E43) | Further debt accumulation (H63) |
| Lack of fiscal authority backing (H69) | Larger fiscal imbalances (H69) |
| Larger fiscal imbalances (H69) | Higher inflation expectations (E31) |
| Lack of coordination between fiscal and monetary policies (E61) | Output contraction (E31) |
| Fiscal authority ignoring public debt (H69) | Explosive dynamics in inflation and debt (E31) |
| Central bank attempts to control inflation without fiscal backing (E58) | Ineffective and counterproductive outcomes (I24) |
| Postponement of necessary fiscal adjustments (H69) | Rise in inflation expectations (E31) |
| Coordinated commitment to inflate away debt (E62) | Better macroeconomic outcomes (E19) |