Monetary policy and fiscal limits with no-default

Research output: Contribution to journalArticlepeer-review


This paper discusses monetary and fiscal policy interactions that stabilize government debt. Two distortions prevail in the model economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include a ceiling on the equilibrium debt-to-GDP ratio, zero or negative elasticity of tax revenues, and a political intolerance of raising tax rates. At the fiscal limit two mechanisms restore solvency: fiscal inflation, which reduces the real value of nominal debt, and open market operations, which diminish the size of government debt held by the private sector. Three regimes achieve this goal. In all regimes monetary policy is passive. In all regimes a muted tax response to government debt is consistent with equilibrium. The propensity of a fiscal authority to smooth output is found to determine what is an acceptable response (in the form of tax rate changes) to the level of government debt, while monetary policy determines the timing and magnitude of fiscal inflation. Impulse responses show that the inflation and tax hikes needed to offset a permanent shock to transfers are lowest under nominal interest rate pegs. In this regime, most of the reduction in the real value of government debt comes from open market purchases.

Original languageEnglish
Pages (from-to)285-304
Number of pages20
JournalEuropean Economic Review
StatePublished - Nov 2013


  • Debt devaluation
  • E42
  • E62
  • E63
  • Fiscal limits
  • Fiscal theory of prices
  • H60
  • Monetary fiscal regimes
  • Open market operations

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics


Dive into the research topics of 'Monetary policy and fiscal limits with no-default'. Together they form a unique fingerprint.

Cite this