Nominal Debt as a Burden on Monetary Policy
We study the effects of nominal debt on the optimal sequential choice of monetary
and debt policy. When the stock of debt is nominal, the incentive to generate
unanticipated inflation increases the cost of the outstanding debt even if no unanticipated
inflation episodes occur in equilibrium. Without full commitment, the
optimal sequential policy is to deplete the outstanding stock of debt progressively
until these extra costs disappear. Nominal debt is therefore a burden on monetary
policy, not only because it must be serviced, but also because it creates a time
inconsistency problem that distorts interest rates. The introduction of alternative
forms of taxation may lessen this burden, if there is enough commitment to fiscal
policy.