• Jun 03
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  Thursday 3 June 2021, 4:30 PM

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Francesco Bianchi (Duke University, CEPR and NBER) - Monetary and Fiscal Policies in Times of Large Debt: Unity is Strength

Co-authors: Renato Faccini (Danmarks Nationalbank, Queen Mary University of London, Centre for Macroeconomics (LSE)) and Leonardo Melosi (FRB Chicago, EUI and CEPR

Abstract

We use a state-of-the-art estimated model augmented with a rich fiscal block and distortionary taxation to illustrate the policy trade-off that arises because of the large debt accumulation caused by the COVID recession. If policymakers implement fiscal adjustments, the economy could experience a prolonged period of economic stagnation. If instead policymakers give in to the temptation of correcting the large fiscal imbalance with higher inflation, a prolonged period of heightened macroeconomic volatility could follow. A coordinated strategy between the monetary and fiscal authorities to inflate away a fraction of the large debt mitigates this trade-off by separating the short-run need to stimulate the economy during the large recession from the issue of long-run fiscal sustainability. The coordinated strategy acts as an automatic stabilizer, mitigating the severity of the pandemic recession. Thus, in equilibrium, the rise in the debt-to-output ratio is contained and so is the increase in inflation needed to stabilize it.

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