Active monetary policy, passive fiscal policy and the value of public debt: Some further monetarist arithmetic

Abstract

We compare the properties of a `constant money growth rule' and a `strict inflation targeting rule' in an intertemporal equilibrium model with flexible prices in which monetary policy is `active', while fiscal policy is `passive'. The paper shows that dynamic properties of the economy may differ significantly between the two monetary policy rules if public debt is issued in nominal terms. Under a constant money growth rule which allows for temporary deviations of inflation from target in response to shocks there is scope for revaluations of public debt, acting as automatic stabilizers of government debt dynamics. By contrast, a policy of strict inflation targeting implements the target inflation rate also outside the steady state and precludes such stabilizing revaluations. Owing to this feature, additional fiscal restraint may be needed which is not required under a constant money growth rule.