Is the Quantity of Debt a Constraint on Monetary Policy?

Monetary authorities have often voiced their concerns about a high debt level that could potentially restrain their ability to control the short-term interest rate as an instrument of monetary policy. However, monetary policy rules in the literature do not account for such constraints. This paper derives an augmented interest rate rule in which the response of the interest rate to expected inflation changes with the level of debt-to-GDP ratio. In particular, the interest rate response of the central bank towards an increase in expected inflation falls as debts increase beyond a certain threshold level. We estimate this threshold level for Canada and find traces of evidence of its monetary policy having been constrained by debt during its inflation-targeting regime of the 1990s.