Fiscal Dominance: How Worried Should We Be?

Abstract

Fiscal dominance, the phenomenon where government spending and debt influence monetary policy decisions, presents a potential threat to central bank independence and inflation control. While not an immediate inevitability, the scenario raises concerns. In this policy brief, Eric Leeper highlights two key worries. One, demographic shifts and gradual fiscal pressures can create a false sense of security, masking the potential for inflation down the road. Two, unlike external shocks, fiscal dominance is largely self inflicted and therefore controllable. To address this, Leeper concludes that enforceable fiscal rules should balance economic prudence with political realities, recognizing that purely economic rules are unlikely to endure in the real world. The brief emphasizes the importance of vigilance in protecting central bank independence and ensuring long-term economic stability. By acknowledging the risks and taking proactive measures, US policymakers can mitigate the potential dangers of fiscal dominance.

Keywords: monetary policy, inflation, fiscal policy, fiscal theory of the price level, fiscal dominance

JEL Classification: E50, E52, E60, E61, E62, E63, E65, E66