Can Monetary Policy Create Fiscal Capacity?
76 Pages Posted: 30 Aug 2021 Last revised: 5 Nov 2021
Date Written: October 29, 2021
Governments around the world have gone on a massive fiscal expansion in response to the Covid crisis, increasing government debt to levels not seen in 75 years. How will this debt be repaid? What role do conventional and unconventional monetary policy play? We investigate debt sustainability in a New Keynesian model with an intermediary sector, realistic fiscal and monetary policy, endogenous convenience yields, and substantial risk premia. During an economic crisis of the same magnitude as the 2020 Covid recession, increased government spending and lower tax revenue lead to a large rise in government debt and raise the risk of future tax increases. We find that quantitative easing (QE) and a higher inflation target contribute to lowering the debt/GDP ratio and reducing the risk of future tax increases. QE is state- and duration-dependent: while a temporary QE policy deployed in a crisis stimulates aggregate demand, permanent QE crowds out investment and lowers long-run output.
Keywords: monetary policy, fiscal policy, public debt, quantitative easing, forward guidance, long-run risk
JEL Classification: E1, E12, E42, E43, E52, E62, G12, G28, G15, F31
Suggested Citation: Suggested Citation