Inflation-Based Fiscal Consolidation: Does Speed Matter?

The potential role that a permanent increase in the inflation target might have in contributing to debt consolidation has rarely been covered in the literature on the link between inflation and public debt. This paper thus investigates under what conditions a higher inflation target might lead to a reduction in the public debt-to-GDP ratio, in a deterministic environment of a TANK model where monetary and fiscal authorities actively operate. Analysing the economic mechanisms involved led to two key results. Higher inflation has opposite effects on public debt in the short and long term. Initially, a rise in the nominal interest rate induces savers to invest relatively more in bonds. In contrast, once the inflation rate reaches higher values, lower wages and rates of return impact on savers who reduce investments in bonds. The second finding is that fiscal consolidation through higher inflation is far from obvious. Overall, the long-term negative effects of higher inflation on output determine increases in fiscal deficits. Moreover, a slower inflation adjustment path influences households’ expectations, leading to increases in the debt-to-GDP ratio rather than decreases in the short term. In light of that, today more than ever, a traditional fiscal policy aimed at reducing the government’s deficit would be needed. Furthermore, revising the monetary policy strategy to increase the inflation target would not be recommended due to the potentially negative effects higher inflation could have on the economy.