Inflation and the Fiscal Limit

Troy Davig, Eric Leeper and Todd Walker

No 16495, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We use a rational expectations framework to assess the implications of rising debt in an environment with a "fiscal limit." The fiscal limit is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes, so either an adjustment to fiscal spending or monetary policy must occur to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as over the timing of when the fiscal limit is hit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The distribution of outcomes for the path of future inflation has a fat right tail, revealing that only a small set of outcomes imply dire inflationary scenarios. Avoiding these scenarios, however, requires the fiscal authority to renege on some share of future promised transfers.

JEL-codes: E31 E52 E62 (search for similar items in EconPapers)
Date: 2010-10
Note: EFG
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

Published as Davig, Troy & Leeper, Eric M. & Walker, Todd B., 2011. "Inflation and the fiscal limit," European Economic Review, Elsevier, vol. 55(1), pages 31-47, January.

Downloads: (external link)
http://www.nber.org/papers/w16495.pdf (application/pdf)

Related works:
Journal Article: Inflation and the fiscal limit (2011)
Working Paper: Inflation and the Fiscal Limit (2010)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:16495

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w16495

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().