Working Paper

Nominal debt as a burden on monetary policy

Abstract: We study the effects of nominal debt on the optimal sequential choice of monetary and debt policy. When the stock of debt is nominal, the incentive to generate unanticipated inflation increases the cost of the outstanding debt even if no unanticipated inflation episodes occur in equilibrium. Without full commitment, the optimal sequential policy is to deplete the outstanding stock of debt progressively until these extra costs disappear. Nominal debt is therefore a burden on monetary policy, not only because it must be serviced, but also because it creates a time inconsistency problem that distorts interest rates. The introduction of alternative forms of taxation may lessen this burden, if there is enough commitment to fiscal policy.

Keywords: Monetary policy; Fiscal policy; Financial crises; Debts, Public;

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    Giovannetti, Giorgia

    Marimon, Ramon

    Teles, Pedro

    Diaz-Gimenez, Javier

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series

Publication Date: 2004

Number: WP-04-10