Paper #841

Title:

Nominal debt as a burden on monetary policy

Authors:

Javier Díaz-Giménez, Giorgia Giovannetti, Ramon Marimon and Pedro Teles

Date:

January 2003 (Revised: January 2006)

Abstract:

We study the effects of nominal debt on the optimal sequential choice of monetary 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 commtiment to fiscal policy. If there is full commitment to an optimal fiscal policy, then the resulting monetary policy is the Friedman rule of zero nominal interest rates.

Keywords:

Time-consistency, monetary policy, debt, recursive equilibrium

JEL codes:

E40, E52, E61

Area of Research:

Macroeconomics and International Economics

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