Fiscal Foundations of Inflation: Imperfect Knowledge, Stefano Eusepi and Bruce Preston. October 4, 2013
“This paper proposes a theory of the fiscal foundations of inflation based on imperfect
knowledge and learning. The theory is similar in spirit to, but distinct from, unpleasant
monetarist arithmetic and the fiscal theory of the price level. Because the assumption
of imperfect knowledge breaks Ricardian equivalence, details of fiscal policy, such as the
average scale and composition of the public debt, matter for inflation. As a result, fiscal
policy constrains the efficacy of monetary policy. Heavily indebted economies with debt
maturity structures observed in many countries require aggressive monetary policy to
anchor inflation expectations. The model predicts that the Great Moderation period
would not have been so moderate, had fiscal policy been characterized by a scale and
composition of public debt now witnessed in some advanced economies in the aftermath of the 2007-09 global recession.”
