Working Paper: NBER ID: w5684
Authors: Michael Woodford
Abstract: The paper considers the role of limits upon the permissible growth of public debt, like those stipulated in the Maastricht treaty, in making price stability possible. It is shown that a certain type of fiscal instability, namely variations in the present value of current and future primary government budgets, necessarily results in price level instability, in the sense that there exists no possible monetary policy that results in an equilibrium with stable prices. In the presence of sluggish price adjustment, the fiscal shocks disturb real output and real interest rates as well. On the other hand, shocks of this kind can be eliminated by a Maastricht-type limit on the value of the public debt. In the presence of the debt limit (and under assumptions of frictionless financial markets, etc.), Ricardian equivalence holds, and fiscal shocks have no effects upon real or nominal variables. Furthermore, an appropriate monetary policy rule can ensure price stability even in the face of other kinds of real shocks. Thus the debt limit serves as a precondition for the common central bank in a monetary union to be charged with responsibility for maintaining a stable value for the common currency.
Keywords: Public Debt; Price Stability; Fiscal Policy; Monetary Union
JEL Codes: E62; E63; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| variations in the present value of current and future primary government budgets (H68) | price level instability (E31) |
| fiscal instability (E63) | price level instability (E31) |
| fiscal shocks (E62) | real output (E23) |
| fiscal shocks (E62) | real interest rates (E43) |
| fiscal shocks (E62) | price level fluctuations (E30) |
| Maastricht-type limit on public debt (H63) | elimination of fiscal shocks (E62) |
| fiscal discipline (E62) | effective monetary policy in a monetary union (E52) |
| appropriate monetary policy (E63) | price stability despite other real shocks (E39) |