Fiscal Foundations of Inflation: Imperfect Knowledge

Abstract

This paper proposes a theory of the fiscal foundations of inflation based on imperfect knowledge and learning. Because imperfect knowledge breaks Ricardian equivalence the scale and composition of the public debt matter for inflation. High moderate-duration debt generates wealth effects on consumption demand that impairs the intertemporal substitution channel of monetary policy: aggressive monetary policy is required to anchor inflation expectations. Counterfactual experiments, in an estimated medium-scale DSGE model, reveal the US economy would have been substantially more volatile over the Great Inflation and Great Moderation periods, had average debt been consistent with levels currently observed in Italy or Japan.