Public Debt and Inflation Incentives

We develop a monetary DSGE model with a maturity structure of long-term government debt and analyse the incentives of a government to reduce it real debt burden by increasing inflation temporarily. The success of such a policy crucially depends on the maturity structure of public debt and on the extent to which a central bank can use the credibility of its inflation target to exploit expectations of low inflation. While the former determines the amount of real debt that can be inflated away, the latter determines the degree to which agents can be `fooled' into pricing newly issued debt at relatively low nominal interest rates. We model credibility as slow private-sector learning about the central bank's inflation target, so that slow learning reflects a high credibility of a formerly established target. Calibrating the model to the currently observed maturity structure of U.S. government debt, and simulating the projected increase in debt after the financial crisis, we find that it is difficult to increase inflation under a credible inflation target. Only if the change in the inflation target rate is expected to be permanent, or the average maturity of debt large, can the government significantly reduce its real debt burden.