DP14720 Monetary and Fiscal Policies in Times of Large Debt: Unity is Strength

Author(s): Francesco Bianchi, Renato Faccini, Leonardo Melosi
Publication Date: May 2020
Date Revised: May 2020
Keyword(s): COVID, emergency budget, Fiscal policy, monetary policy, shock specific rule
JEL(s): E30, E50, E62
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14720

The COVID pandemic found policymakers facing constraints on their ability to react to an exceptionally large negative shock. The current low interest rate environment limits the tools the central bank can use to stabilize the economy, while the large public debt curtails the efficacy of fiscal interventions by inducing expectations of costly fiscal adjustments. Against this background, we study the implications of a coordinated fiscal and monetary strategy aiming at creating a controlled rise of inflation to wear away a targeted fraction of debt. Under this coordinated strategy, the fiscal authority introduces an emergency budget with no provisions on how it will be balanced, while the monetary authority tolerates a temporary increase in inflation to accommodate the emergency budget. In our model the coordinated strategy enhances the efficacy of the fiscal stimulus planned in response to the COVID pandemic and allows the Federal Reserve to correct a prolonged period of below-target inflation. The strategy results in only moderate levels of inflation by separating long-run fiscal sustainability from a short-run policy intervention.