(Optimal) Monetary Policy with and without Debt
Since the 2008–09 recession, governments in developed economies have accumulated large amounts of debt. This has been particularly exacerbated in the current context, where governments are tackling the consequences of COVID-19. High debt levels require bold fiscal adjustments to ensure solvency of government budgets. But it is questionable whether the large surpluses needed to finance debt will be possible in the future.
We propose a framework where monetary policy can ensure debt sustainability when fiscal policy cannot generate enough surplus. We show that when optimal policy reveals “debt concerns,” monetary policy takes a back seat and must partially forgo its objective of stabilizing inflation and the output gap. This allows for the consolidated budget to be satisfied. In liquidity trap episodes, committing to keeping interest rates low for a long period leads to deflation rather than to an increase in the inflation rate.
Instead, when there are no debt concerns, monetary policy is active and does not consider debt sustainability. It can continue to effectively stabilize the macroeconomy. A medium-scale version of our model with US data confirms our theoretical findings.