The perils of narrowing fiscal spaces
Summary
Focus
Elevated fiscal imbalances are fundamentally reshaping the relationship between monetary and fiscal authorities worldwide, eroding long-standing institutional boundaries. For decades, the prevailing paradigm rested on a sharp separation, with monetary policy operating independently from fiscal considerations. Today, however, with the accumulation of large sovereign debt stocks, interest rate decisions have become increasingly consequential for governments' fiscal space, as higher borrowing costs translate directly into budgetary strain. Central banks therefore face mounting pressure to ease monetary policy in order to avoid further constraining fiscal capacity.
Contribution
We formalise the fiscal constraint on monetary policy within a non-linear New Keynesian framework in which the constraint is state-dependent and varies with the severity of the prevailing fiscal imbalance. The core innovation is the introduction of an endogenous fiscal constraint that operates as an upper bound on the policy interest rate. This constraint is derived from a structural ceiling on the debt-to-output ratio and tightens as fiscal conditions deteriorate. The framework thereby identifies a fiscal "tipping point" beyond which further interest rate increases would generate severe macroeconomic and political consequences, including intensified political backlash stemming from the exhaustion of fiscal policy space.
Findings
High public debt dampens the monetary policy response to inflation, resulting in more persistent upward price pressures. This effect is particularly pronounced during cost-push shocks, when the fiscal constraint binds precisely as inflation accelerates, severely curtailing the central bank's capacity to tighten policy. In demand-driven downturns, the fiscal constraint may become more restrictive than the zero lower bound, ultimately forcing the central bank to either resort to monetary financing of excess public debt or acquiesce to a regime of fiscal dominance.
Abstract
When public debt is elevated, the fiscal cost of fighting inflation rises sharply, as interest rate hikes increase government interest expenditures. We formalize this mechanism in a nonlinear New Keynesian model with a state-dependent fiscal constraint on monetary policy. High debt may dampen the monetary response to inflation, generating an inflationary bias even though government debt remains fully fiscally backed. The interaction between high debt and inflationary cost-push shocks makes the fiscal limit more likely to bind, amplifying inflation. In demand-driven downturns, the fiscal constraint may become more restrictive than the zero lower bound, forcing the central bank to either print money to purchase excess debt or accept fiscal dominance.
JEL Classification: E31, E52, E62, E58
Keywords: fiscal limits, public debt, monetary policy, inflation, zero lower bound, fiscal space, nonlinear new Keynesian models
