Effects of Fiscal Policy on the Durability of Low Inflation Regimes

This paper deals with the interaction of fiscal and monetary policy when the central bank is pursuing a price stability-oriented monetary policy. In particular, we study the durability of the price stability regime when public debt accumulates as a result of ultimately unsustainable deficits. The growth of indebtedness causes the collapse of the price stability regime after a period of rising deficits. The budget deficit is endogenously determined in the model, as a result of government's decisions on how to finance its expenditure. The alternative methods of finance are taxes, debt, and seigniorage. Under the price stability regime, only the first two methods are available, but in the long run taxes and seigniorage are the only alternatives. The price stability regime collapses when the public debt reaches an edogenously determined threshold, which makes reneging on price stability as attractive as accumulating more tax burden for the future. We are able to solve for the critical level of debt, the timing of the collapse, and the reaction of taxes to the collapse of the price stability regime. The critical level of debt depends, inter alia, on the level of government consumption, the real interest rate, the velocity of money, and the efficiency-effects of taxation. The results are illustrated by several numerical simulations