Temporarily Unstable Government Debt and Inflation

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 growing promised government transfers that initially are fully honored, being financed by new sales of government debt that bring forth higher Attire 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, temporarily, debt grows rapidly. Eventually, a new stabilizing combination of policies is adopted. We examine how, in the period before the fiscal limit, rapidly rising debt interacts with expectations of how and when policies will adjust. If households believe it is possible that in the future monetary policy will shift from targeting inflation to stabilizing debt, then temporarily explosive debt feeds directly into the path of inflation. News that reduces expected primary surpluses can bring future inflation into the present, well before the news shows up in fiscal measures. This paper makes the point that even if long-run policies give monetary policy perfect control over inflation, in the transition to that long run, monetary policy can spectacularly lose control. [JEL H60, E30, E62, H30] IMF Economic Review (2011) 59, 233-270. doi :10.1057/imfer.2011.7