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Sticky Inflation: Monetary Policy when Debt Drags Inflation Expectations

Author

Listed:
  • Saki Bigio
  • Nicolas Caramp
  • Dejanir Silva
  • Dejanir H. Silva

Abstract

We append the expectation of a monetary-fiscal reform into a standard New Keynesian model. If a reform occurs, monetary policy will temporarily aid debt sustainability through a temporary burst in inflation. The anticipation of a possible reform links debt levels with inflation expectations. As a result, interest rates have two effects: they influence demand and affect expected inflation in opposite directions. The expectations effect is linked to the impact of interest rates on public debt. While lowering inflation in the short term is possible through demand control, inflation tends to rise again due to its impact on inflation expectations (sticky inflation). Optimal monetary policy may allow low real interest rates after fiscal shocks, temporarily breaking away from the Taylor principle. We assess whether the Federal Reserve’s “staying behind the curve” was the right strategy during the recent post-pandemic inflation surge.

Suggested Citation

  • Saki Bigio & Nicolas Caramp & Dejanir Silva & Dejanir H. Silva, 2024. "Sticky Inflation: Monetary Policy when Debt Drags Inflation Expectations," CESifo Working Paper Series 11495, CESifo.
    • Handle: RePEc:ces:ceswps:_11495
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    More about this item

    Keywords

    monetary policy; monetary-fiscal coordination; inflation expectations;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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