Working Paper: NBER ID: w25658
Authors: Eric M. Leeper; Campbell B. Leith; Ding Liu
Abstract: The textbook optimal policy response to an increase in government debt is simple—monetary policy should actively target inflation, and fiscal policy should smooth taxes while ensuring debt sustainability. Such policy prescriptions presuppose an ability to commit. Without that ability, the temptation to use inflation surprises to offset monopoly and tax distortions, as well as to reduce the real value of government debt, creates a state-dependent inflationary bias problem. High debt levels and short-term debt exacerbate the inflation bias. But this produces a debt stabilization bias because the policy maker wishes to deviate from the tax smoothing policies typically pursued under commitment, by returning government debt to steady-state. As a result, the response to shocks in New Keynesian models can be radically different, particularly when government debt levels are high.
Keywords: Monetary Policy; Fiscal Policy; Debt Maturity; Inflation Bias
JEL Codes: E62; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high levels of government debt (H63) | inflation bias (E31) |
| short-term debt (H63) | inflation bias (E31) |
| policy maker's temptation to use inflation surprises (E31) | inflation bias (E31) |
| high debt levels (F34) | inclination to generate inflation surprises (E31) |
| inflation bias (E31) | inflation expectations influenced by real value of outstanding debt (E31) |
| myopic policy maker (E60) | sustain higher debt and inflation in the long run (H63) |
| response to cost-push shocks (E31) | mitigate fiscal repercussions (E62) |
| allowing policy makers to choose proportions of short vs long-term debt (H63) | modest issuance of short-term debt alongside long-term debt (H63) |
| modest issuance of short-term debt alongside long-term debt (H63) | alters the policy mix and affects fiscal consolidation efforts (E62) |