Public Debt, Distortionary Taxation, and Monetary Policy

Alessandro Piergallini and Giorgio Rodano ()

MPRA Paper from University Library of Munich, Germany

Abstract: Since Leeper's (1991, Journal of Monetary Economics 27, 129-147) seminal paper, an extensive literature has argued that if fiscal policy is passive, i.e., guarantees public debt stabilization irrespectively of the inflation path, monetary policy can independently be committed to inflation targeting. This can be pursued by following the Taylor principle, i.e., responding to upward perturbations in inflation with a more than one-for-one increase in the nominal interest rate. This paper analyzes an optimizing framework in which the government can only finance public expenditures by levying distortionary taxes. It is demonstrated that households' market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate.

Keywords: Public Debt; Distortionary Taxation; Monetary and Fiscal Policy Rules (search for similar items in EconPapers)
JEL-codes: E63 H31 H63 (search for similar items in EconPapers)
Date: 2010-10-30
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon, nep-pbe and nep-pub
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Journal Article: Public Debt, Distortionary Taxation, and Monetary Policy (2012)
Working Paper: Public Debt, Distortionary Taxation, and Monetary Policy (2012)
Working Paper: Public Debt, Distortionary Taxation, and Monetary Policy (2009)
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