Fiscal Constraints on Monetary Policy: How Debt Limits Monetary Effectiveness

Christian Bayer, Zheng Gong and Keith Kuester

No 21995, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Monetary policy invariably leaves a fiscal footprint; not only whether but also when that footprint is eliminated is central to monetary transmission. We provide closed-form solutions for a New Keynesian model with government debt. Debt provides liquidity services. Debt, thus, affects the natural rate of interest. We show how the timing of fiscal adjustment shapes the effects of monetary tightening. As adjustment is deferred, outcomes become reminiscent of active fiscal policy, even if fiscal policy is known eventually to absorb the footprint: Even with finite fiscal delays, a rate hike can become inflationary, and potentially expansionary. The effect is found in data and quantitatively also in a richer quantitative HANK-OLG.

Keywords: fiscal-monetary interaction; liquidity services of government debt; Olg (search for similar items in EconPapers)
JEL-codes: E52 E62 E63 H63 (search for similar items in EconPapers)
Date: 2026-09
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