While it is well understood theoretically that higher inflation will lower the real value of outstanding government debt, empirically there is neither a method nor plausible estimates of how large this effect will be. We propose a method that takes an ex ante perspective of the government budget constraint, and relies on having detailed information on debt held by the public at different maturities, risk-neutral densities for future inflation at different horizons, and a set of plausible counterfactuals. Applying it to the United States in 2012, we estimate that the effects of higher inflation on the fiscal burden are modest. A more promising route to inflate away the public debt is to use financial repression, and we estimate that a decade of repression combined with inflation could wipe out almost half of the debt.

This paper shows that cross-border capital flows within the EMU may have contributed up to 370 basis points to sovereign spreads during the crisis. Mechanisms through which these capital flows can have affected sovereign bond yields include changes in sovereign fiscal positions, the tight link between banking and sovereign health, the lack of domestic monetary policy tools and the lack of a country-specific exchange rate mechanism.

Discussion Papers represent the authors ‘ personal opinions and do not necessarily reflect the views of the Deutsche Bundesbank or its staff. Editorial Board:

Government debt, inflation dynamics and the transmission of fiscal policy shocks

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This paper investigates the impact of low or high inflation on the public debt-to-GDP ratio in the G-7 countries. Our simulations suggest that if inflation were to fall to zero for five years, the average net debt-to-GDP ratio would increase by about 5 percentage points over the next five years. In contrast, raising inflation to 6 percent for the next five years would reduce the average net debt-to-GDP ratio by about 11 percentage points under the full Fisher effect and about 14 percentage points under the partial Fisher effect. Thus higher inflation could help reduce the public debt-to-GDP ratio somewhat in advanced economies. However, it could hardly solve the debt problem on its own and would raise significant challenges and risks. First of all, it may be difficult to create higher inflation, as evidenced by Japan’s experience in the last few decades. In addition, un-anchoring of inflation expectations could increase