Fiscal Limits and Monetary Policy

Abstract

Every economy faces a "fiscal limit" that delivers the maximum government debt-GDP ratio that can be sustained without appreciable risk of default or higher inflation.But governments in advanced economies issue substantial nominal debt and nominal debt is a commitment to repay in nominal units.When such economies are approaching their fiscal limits, debt can be devalued through higher current and future inflation rates.The paper develops a simple bond market supply-demand apparatus to explain how fiscal policy can be a source of inflation, while monetary policy merely determines the timing of inflation.

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