Temporarily Unstable Government Debt and Inflation

Troy Davig and Eric Leeper

No 16799, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Many advanced economies are heading into an era of fiscal stress: populations are aging and governments have made substantially more promises of old-age benefits than they have made provisions to finance. This paper models the era of fiscal stress as stemming from relentlessly growing promised government transfers that initially are fully honored, being financed by new sales of government debt that bring forth higher future income taxes. As debt levels and tax rates rise, the population's tolerance for taxation declines and the probability of reaching the fiscal limit increases. At the limit a fixed tax rate is adopted, adjustments in taxes no longer stabilize debt, and some new stabilizing combination of policies must arise. We examine how, in the period before the fiscal limit, rapidly rising debt interacts with expectations of how and when policies will adjust. Temporarily explosive debt has no effect on inflation if households expect all adjustments to occur through entitlements reform, but if households believe it is possible that in the future monetary policy will shift from targeting inflation to stabilizing debt, then debt feeds directly into the path of inflation and monetary policy can no longer control inflation. News that reduces expected primary surpluses can bring future inflation into the present, well before the news shows up in fiscal measures.

JEL-codes: E31 E52 E62 E63 (search for similar items in EconPapers)
Date: 2011-02
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Note: EFG
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Citations: View citations in EconPapers (13)

Published as Troy Davig & Eric M Leeper, 2011. "Temporarily Unstable Government Debt and Inflation," IMF Economic Review, Palgrave Macmillan, vol. 59(2), pages 233-270, June.

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