Sustainable Monetary and Fiscal Policy in High Debt Scenarios

Skyrocketing debt-to-GDP ratios in the wake of the global coronavirus pandemic again brought the question of fiscal sustainability into focus. This paper evaluates sustainable monetary and fiscal policy coordination in high debt scenarios. In particular, it compares policy interactions in NK models with and without the fiscal theory of the price level (FTPL). In a policy regime with monetary dominance, my analysis suggest that high debt levels significantly hamper the effectiveness of future monetary and fiscal policy and thus decrease fiscal space. In fact, without a sufficiently large fiscal backing, approaching higher debt-to-GDP ratios results in explosive dynamics or in situations where temporary policy shocks nearly permanently derail model responses. I illustrate these finding with a meticulous comparison of different combinations of monetary and fiscal policies. Furthermore, I highlight my results by analyzing the effects of permanently reducing the US debt, accumulated during the COVID-19 Pandemic. Depending on the policy mix, there is a trade-off between higher future taxes and higher future inflation.