The effects of monetary policy shocks on inflation: The role of backed and unbacked public debt in a monetary and fiscal policy regime mix

The present study evaluates the role played by backed and unbacked public debt in the propagation of a contractionary monetary policy shock to inflation dynamics under three different policy mix regimes. It shows that a coexistence regime with partially unbacked public debt is able to achieve comparatively lower inflation than Regime F, in which public debt is not backed at all and, at the same time, achieves a relatively well-stabilized public debt level in comparison to Regime M, in which public debt is backed fully. The proposed coexistence regime also performs better, in terms of welfare, than both Regime M and Regime F. Under the coexistence regime, when inflation is mainly fiscal in nature, authorities face higher levels of volatility for both public debt and inflation and a significant trade-off between the respective volatility of public debt and inflation. When prices become more sticky, debt service costs become much higher than those observed in a relatively flexible price scenario, resulting in a more significant increase in public debt following the shock. In order to effectively stabilize both public debt and inflation, policymakers need both to ascertain the extent to which a monetary policy shock influences the unbacked component of public debt and to carefully establish the right mix of monetary and fiscal policy for debt stabilization.