Control of the Public Debt: A Requirement for Price Stability?

39 Pages Posted: 18 Nov 1996 Last revised: 3 Oct 2010

See all articles by Michael Woodford

Michael Woodford

Columbia University, Graduate School of Arts and Sciences, Department of Economics; National Bureau of Economic Research (NBER)

Date Written: July 1996

Abstract

The paper considers the role of limits upon the permissible growth of public debt, like those stipulated in the Maastricht treaty, in making price stability possible. It is shown that a certain type of fiscal instability, namely variations in the present value of current and future primary government budgets, necessarily results in price level instability, in the sense that there exists no possible monetary policy that results in an equilibrium with stable prices. In the presence of sluggish price adjustment, the fiscal shocks disturb real output and real interest rates as well. On the other hand, shocks of this kind can be eliminated by a Maastricht-type limit on the value of the public debt. In the presence of the debt limit (and under assumptions of frictionless financial markets, etc.), Ricardian equivalence holds, and fiscal shocks have no effects upon real or nominal variables. Furthermore, an appropriate monetary policy rule can ensure price stability even in the face of other kinds of real shocks. Thus the debt limit serves as a precondition for the common central bank in a monetary union to be charged with responsibility for maintaining a stable value for the common currency.

Suggested Citation

Woodford, Michael, Control of the Public Debt: A Requirement for Price Stability? (July 1996). NBER Working Paper No. w5684. Available at SSRN: https://ssrn.com/abstract=3508

Michael Woodford (Contact Author)

Columbia University, Graduate School of Arts and Sciences, Department of Economics ( email )

420 W. 118th Street
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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