Idiosyncratic Risk, Government Debt and Inflation

TL;DR

This paper explores how public debt influences inflation through its effect on interest rates and risk, using analytical and quantitative models to explain recent US inflation trends.

Contribution

It introduces a model showing that even temporary government debt can raise interest rates and inflation, with implications depending on asset market structure and monetary policy.

Findings

Public debt can exert upward pressure on interest rates and inflation.

Asset market structure critically influences the magnitude of debt's effects.

The model explains sustained US inflation in 2023 and beyond.

Abstract

How does public debt matter for price stability? If it is useful for the private sector to insure idiosyncratic risk, even transitory government debt expansions can exert upward pressure on interest rates and create inflation. As I demonstrate using an analytically tractable model, this holds in the presence of an active Taylor rule and does not require the absence of future fiscal consolidation. Further analysis using a quantitative 2-asset HANK model reveals the magnitude of the mechanism to crucially depend on the structure of the asset market: under common assumptions, the interest rate effects of public debt are either overly strong or overly weak. After disciplining this aspect based on evidence regarding its long-term relationship with treasury returns, my framework indicates relevant short-run effects of public debt on inflation under active monetary policy: In particular, in the HANK model the mechanism can account for US inflation remaining elevated in 2023 and afterwards.