Inflation-based fiscal consolidation: a DSGE approach

This paper investigates under which conditions a permanent increase in inflation target might entail public debt reduction, in a Two Agents New Keynesian model with sticky prices and distortionary taxation. In light of that, this paper contributes to the more recent lively debate among economists and policymakers regarding whether an increase in inflation could contribute to a public debt reduction without damaging macroeconomic stability. Real and welfare effects caused by changes in the inflation target from 2% to 5% are discussed. Overall, results show that an increase in inflation affects the economy positively in the short run but negatively in the long term. Consistently, higher inflation worsens households’ welfare. Moreover, a sensitivity analysis of the model’s key parameters is carried out. Quite interestingly, it emerges that fiscal consolidation through an increase in inflation is far from obvious. A more sluggish inflation adjustment path influences households’ expectations, entailing debt-to-GDP ratio increases rather than decreases.