DP18887 The Monetary Financing of a Large Fiscal Shock
Motivated by the surge in debt levels through the pandemic crisis, we revisit the issue of the optimal financing of public debt. In contrast with the existing literature, we find that the optimal response of inflation to a large increase in debt levels is a gradual but significant and long-lasting rise in inflation. The difference in our results is due to a different assumption on the source of nominal rigidities. While the literature has focused on sticky prices, of either the Calvo or Rotemberg type, we consider sticky plans as in the sticky information set up of Mankiw and Reis (2002). A crucial feature of our results is that a significant inflation response is desirable only if the maturity of debt is (realistically) long. In a calibrated example, we show that QE policies, by reducing the maturity of the debt held by the private sector, may lead to an optimally higher response of inflation.
