Research Discussion Papers, Bank of Finland
Effects of fiscal policy on the durability of low inflation regimes
Abstract: 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.
Keywords: inflation; fiscal policy; fiscal theory of inflation; Stability and Growth Pact; (follow links to similar papers)
JEL-Codes: E52; E62; E63; F36; (follow links to similar papers)
34 pages, June 26, 2002
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