Can Monetary Policy Create Fiscal Capacity?

76 Pages Posted: 30 Aug 2021 Last revised: 5 Nov 2021

See all articles by Vadim Elenev

Vadim Elenev

Johns Hopkins Carey Business School

Tim Landvoigt

University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Patrick Shultz

University of Pennsylvania - Finance Department

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); ABFER

Multiple version iconThere are 3 versions of this paper

Date Written: October 29, 2021

Abstract

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

Elenev, Vadim and Landvoigt, Tim and Shultz, Patrick and Van Nieuwerburgh, Stijn, Can Monetary Policy Create Fiscal Capacity? (October 29, 2021). Available at SSRN: https://ssrn.com/abstract=3896402 or http://dx.doi.org/10.2139/ssrn.3896402

Vadim Elenev

Johns Hopkins Carey Business School ( email )

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Tim Landvoigt (Contact Author)

University of Pennsylvania - The Wharton School ( email )

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Philadelphia, PA 19104-6365
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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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Patrick Shultz

University of Pennsylvania - Finance Department ( email )

The Wharton School
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United States

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business ( email )

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United States

HOME PAGE: http://https://www0.gsb.columbia.edu/faculty/svannieuwerburgh/

National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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ABFER ( email )

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