Is the Quantity of Government Debt a Constraint for Monetary Policy?
IMF Working Papers, March 1, 2007
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- Is the Quantity of Government Debt a Constraint for Monetary Policy?
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Bibliographic details
- Authors: Srobona Mitra
- Published: March 1, 2007
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451866261.001
Summary and purpose
- Derives an interest rate rule for monetary policy in which the interest rate response of the central bank toward an increase in expected inflation falls as debts increase beyond a certain threshold level.
- Jointly estimates a debt-constrained interest rate rule and the threshold level of debt for Canada during the first decade of its inflation targeting regime of the 1990s.
- Focuses on how a high government debt-GDP ratio can alter the policy transmission mechanism and constrain monetary policy.
Key findings
- A high government debt could constrain monetary policy if government spending—rather than taxes—is expected to adjust in future in line with debt service costs.
- The 'constraint' operates through an altered policy transmission mechanism via changes in the IS curve.
- The effects of the debt-constraint on monetary policy are quite different during booms and recessions.
- Empirical estimates indicate that Canadian monetary policy might have been constrained by a high government debt-GDP ratio during the 1990s.
- Policy was less loose than what inflation indicators called for.
Methodology and scope
- The paper derives an interest rate rule that endogenously incorporates a debt threshold beyond which the central bank’s interest rate response to expected inflation diminishes.
- Estimation is conducted for Canada during the first decade of its inflation targeting regime of the 1990s.
Policy implications and interpretation
- If future fiscal adjustment is expected to occur through government spending cuts linked to debt service costs, high debt can meaningfully limit the central bank’s ability to respond to inflation pressures.
- Monetary policy reactions to inflation should account for fiscal structure (spending vs. taxes) and the state of the business cycle, since constraints differ in booms versus recessions.
- Historical evidence for Canada in the 1990s suggests that failure to account for debt-induced constraints may lead to a monetary stance that is tighter than inflation indicators alone would justify.
Subject classification and keywords
- Subject: Inflation, Output gap, Public debt, Real interest rates, Short term interest rates
- Keywords: interest rate, monetary policy, WP