Household Beliefs about Fiscal Dominance 
An increasing debt-to-GDP ratio can become inflationary when a central bank, faced with large public debt, is reluctant to raise interest rates enough to fight price pressures because such an increase could make interest payments on past public debt too expensive and thus endanger its sustainability. This mechanism is associated with the risk of fiscal dominance, a state in which accumulating government debt constrains a central bank’s ability to manage inflation through monetary policy. This risk can affect household views about future inflation, and such views can, in turn, affect current inflation through their impact on wages and aggregate demand. This paper introduces a methodology for investigating whether households consistently connect debt and inflation expectations with beliefs about fiscal dominance. The authors apply this methodology to data from a customized survey administered to a representative sample of German households. The survey includes questions that elicit households’ views on fiscal policy and information treatments that generate exogenous shocks to households’ debt expectations.
Key Findings
- The survey data indicate that, on average, news leading individuals to expect a higher debt-to-GDP ratio leads them to also revise their inflation expectations upward, although moderately.
- Results from the survey also show that these average effects are driven by individuals who think that fiscal resources are stretched—a situation where the increase in public debt cannot be fully funded by additional fiscal resources. By contrast, individuals who think there is fiscal space do not associate debt with future inflation.
- Results from a standard New Keynesian model featuring heterogeneous beliefs about fiscal space show that the presence of fiscal dominance expectations implies a policy tradeoff for the central bank: Expectations of higher inflation tomorrow lead to higher inflation today, and the central bank needs to tighten policy today to offset these beliefs. Because the contractionary impact of such a tightening is costly, the central bank can decide to accept some increase in inflation.
Implications
The paper’s findings imply that even if a central bank is credibly perceived as being committed to price stability, inflation can emerge when fiscal dominance risks do. Those risks ultimately result from beliefs about budget constraints and fiscal space, which are perceptions that a central bank cannot completely control.
Abstract
We study beliefs about fiscal dominance using a survey of German households. We first design and conduct a randomized controlled trial to identify how fiscal news impacts individuals’ debt-to-GDP and inflation expectations. We document that the link between debt and inflation crucially depends on individuals’ views about the fiscal space. News leading individuals to expect a higher debt-to-GDP ratio makes them more likely to revise their inflation expectations upward. These average effects are driven by individuals who think that fiscal resources are stretched. By contrast, individuals who think there is fiscal space do not associate debt with inflation. We then introduce a New Keynesian model in which agents have heterogeneous beliefs about the fiscal space. We show that such a heterogeneity of beliefs implies a policy tradeoff for the central bank: Agents who expect fiscal dominance in the future exert upward pressure on inflation, which the central bank should partially tolerate due to the real costs of completely stabilizing prices.