Public Debt and the Price Level ∗

This paper considers whether monetary and fiscal policy may sensibly be formulated independently of one another, and argues that the reasons for the two to be interconnected go well beyond the familiar but unappealing possibility of using seignorage as a source of revenue for the government. Particular attention is given to the effects of fiscal policy upon the price level through the wealth effect of variations in the value of the public debt; such effects are shown to be consistent with rational expectations and frictionless financial markets, contrary to the doctrine of “Ricardian equivalence”, in the case of “non-Ricardian” fiscal policy. In this case, the effects of variation in the composition of the public debt (as to maturity and degree of indexation) are considered, as well as the effects of growth in its overall size. A number of objections to the possibility of a non-Ricardian policy are considered, notably the assertions that it is not possible for a government to refuse to adjust its budget when its debts grow too large, and the assertion that equilibria in which the price level is determined by the government budget depend upon an implausible equilibrium selection in a model with multiple rational expectations equilibria. The effects of public debt upon the price level are also considered in the case that consumers have adaptive rather than rational expectations about their lifetime budgets. Finally, the nature of optimal fiscal and monetary policy is considered, as a problem of dynamic Ramsey taxation. It is shown that an optimal policy regime may well involve a “non-Ricardian” fiscal policy, in which increases in govermment purchases do not result in corresponding increases in the present value of future tax collections, and so cause fluctuations in the equilibrium value of government bonds. At the same time, an appropriate choice both of monetary policy and of the composition of the public debt can make this sort of fiscal policy compatible with a substantial degree of price stability. ∗Prepared for the Bank of England conference on Government Debt and Monetary Policy, June 18-19, 1998. I wish to thank Matt Canzoneri, Eduardo Loyo and Bennett McCallum for helpful discussions, and the National Science Foundation for research support through a grant to the NBER. Recent years have seen a worldwide movement toward greater emphasis upon the achievement of inflation targets as the primary criterion for judging the success of central banks’ conduct of monetary policy. At the same time, the independence of central banks in their choice of the means with which to pursue this goal has also increased. The implication would seem to be that it is now widely accepted that the choice of monetary policy to achieve a target path for inflation is a problem that can be, and indeed ought to be, separated from other aspects of government policy, such as the choice of fiscal policy. But is this really so clear? Or do the agencies responsible for inflation stabilization properly need to concern themselves with fiscal policy choices as well, while the agencies concerned with fiscal policy have a corresponding need to coordinate their actions with those of the monetary authority? The argument for separation of decision-making about these two aspects of macroeconomic policy necessarily relies upon two theses: first, that fiscal policy is of little consequence as far as inflation determination is concerned, and second, that monetary policy has little effect upon the government budget. We shall argue here that neither proposition is true, for reasons that are related. The fiscal effects of monetary policy are often thought to be an insignificant consideration in the choice of monetary policy by the major industrial nations, because seignorage revenues are such a small fraction of total government revenues in these countries. But such a calculation neglects a more important channel for fiscal effects of monetary policy, namely the effects of monetary policy upon the real value of outstanding government debt, through its effects upon the price level (given that much of the public debt is nominal) and upon bond prices, and upon the real debt service required by such debt (insofar as monetary policy can affect real as well as nominal interest rates). Fiscal policy is often thought to be unimportant for inflation determination – at least when, as in countries like the U.S. and the U.K., a desire to obtain seignorage revenues plays no apparent role in the choice of monetary policy – on two different, though complementary, A particularly extreme example of a proposal to separate the two types of policy decisions is the European monetary union provided for by the Maastricht treaty, which will make monetary policy the responsibility of a supra-national European Central Bank, while fiscal policies continue to be the prerogatives of individual national governments. See King (1995) for discussion of this point, with some quantitative evidence.