Monetary Commitment and the Level of Public Debt

In the case of closed-loop strategies, the central bank announces targets for the nominal interest rate and inflation.1 The nominal interest rate is set equal to its target only if fiscal policy is consistent with the inflation target. [...] The policy game A formal description of the game allows us to be transparent about the assumptions we make about the strategies available to the monetary and fiscal authorities. [...] Given the institutional set-up, we define the equilibrium as follows: (i) fiscal policy σ∗f is Markov-perfect; and (ii) given σ∗f and φπ, the optimal monetary strategy, σ∗m, maximizes U0 in the class of closed-loop strategies of the form (27). [...] The equilibrium level of debt is such that, net of the resource cost, the temptation to raise inflation above its steady state to close the output gap is exactly compensated for by the incentive to reduce it to raise real revenues – something that arises only when the government is a creditor. [...] Therefore, the stronger the response of the nominal interest rate, the lower will be the level of debt.