Debt-Contingent Inflation Contracts and Targets

Abstract

This paper analyzes fiscal and monetary policy interaction in a simple policy game with debt and output shocks. Seigniorage provides revenue for the government but results in inflation-bias. We analyze three mechanism designed to eliminate some or all of the biases in monetary policy: an inflation performance contract, inflation target (both contingent on the stock of debt), and a zero-inflation rule. The performance contract and inflation target result in higher interest rate, removes all biases in monetary policy and achieves the pre-commitment policy, hence they are equivalent. The first two solutions also yield a higher expected welfare than the zero-inflation rule.