Dormant Shocks and Fiscal Virtue

Leonardo Melosi and Francesco Bianchi

No 44, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: We develop a model in which the current behavior of the fiscal and monetary authorities influence agents' beliefs about the way debt will be stabilized. The standard policy mix consists of a virtuous fiscal authority that moves taxes in response to debt and a Central Bank that has full control over inflation. When policy makers deviate from this virtuous policy mix, agents conduct Bayesian learning to infer the likely duration of the deviation. As agents observe more and more deviations, they become increasingly pessimistic about a prompt return to the virtuous regime and inflation starts moving to keep debt on a stable path. Shocks which were dormant under the virtuous policy mix start now manifesting themselves. These changes are initially imperceptible, but they unfold over decades and accelerate as agents get convinced that the fiscal authority will not raise taxes. Dormant fiscal shocks can account for the run-up of inflation in the `70s and the deflationary pressure of the early 2000s. We point out that the currently low long term interest rates and inflation expectations might hide the true risk of inflation faced by the US economy.

Date: 2012
New Economics Papers: this item is included in nep-mac and nep-mon
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Related works:
Journal Article: Dormant Shocks and Fiscal Virtue (2014)
Chapter: Dormant Shocks and Fiscal Virtue (2013)
Working Paper: Dormant Shocks and Fiscal Virtue (2013)
Working Paper: Dormant Shocks and Fiscal Virtue (2013)
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