Exiting from quantitative easing in an era of large government debt: Inflation or default?

Abstract

Japanese government bonds have accumulated during the last decades, while the Bank of Japan has purchased government bonds under the Quantitative and Qualitative Monetary Easing. This note reconsiders a relationship between inflation stability and a government bond default by using a simple model in which the fiscal authority: (ⅰ) commits not to making fiscal adjustments needed to stabilize government debt, (ⅱ) commits not to providing financial support for the central bank that incurs losses on its balance sheet, and (ⅲ) can partially default on government bonds. We show that the central bank that engages in large-scale purchases of long-term government bonds when the zero lower bound (ZLB) binds cannot achieve its inflation target after the ZLB is no longer binding.