Traditional views on monetary-fiscal interactions suggest that fiscal deficits can be stabilised through changes in taxes, government spending, or inflation. This column examines how economic growth driven by technological innovation affects price stability and the sustainability of public debt. It argues that there is another stabilisation channel for public debt: economic growth. Increased demand boosts research and development, leading to technology growth which acts as a self-financing mechanism for unfunded deficits. Thus, debt-driven inflation can be less severe than commonly believed. Monetary policy should focus on the dynamics of the real interest rate vis-à-vis the long-term growth rate, rather than considering only the real rate.
Central banks and governments are responsible for keeping prices and sovereign debt levels stable, respectively. Economists have developed models to understand how these requirements can be fulfilled by managing interest rates, taxes, and public spending. The recent rise in sovereign debt across the world has raised questions about debt sustainability (e.g. Taylor et al. 2022), and about how central banks and governments will jointly stabilise debt and inflation moving forward (e.g. Bianchi et al. 2023). This column focuses on an overlooked issue: the effect of technological innovation and long-term economic growth on monetary-fiscal interactions. We show that fiscal expansions can spur economic growth, generating more revenue and less inflation than traditional models predict. Central banks can maintain price stability by carefully balancing interest rates against economic growth rates.
Conventional insights on monetary-fiscal interactions
Economists often consider the debt-to-GDP ratio as a measure of fiscal sustainability, and low inflation (e.g. around 2%) as an indicator of price stability. Theoretical frameworks were developed to understand how monetary policy and fiscal policy should work together to align inflation with a targeted level and keep debt-to-GDP levels manageable over time. Previous results regarding monetary-fiscal interactions (e.g. Leeper 1991) suggest:
- If the government keeps debt-to-GDP stable by adjusting taxes and spending (‘passive’ fiscal policy), then the central bank should raise interest rates by more than inflation rises to keep prices stable (the ‘Taylor Principle’). In this regime of monetary dominance, the government pays for fiscal deficits with future taxes, and the central bank stabilises inflation by raising real interest rates (r) in times of high inflation.
- If the government does not manage sovereign debt by funding deficits through future tax hikes or spending cuts (‘active’ fiscal policy), then the central bank should do the opposite – let real interest rates fall when inflation persists. In this regime of fiscal dominance, fiscal policy is unfunded and central banks manage sovereign debt levels by lowering real interest rates when inflation is high.
Crucially, these results are based on economic models that treat the growth path of the economy as fixed and unaffected by policy decisions. Accordingly, policymakers must manage debt-to-GDP by focusing on the numerator (debt) alone.
A new perspective: Monetary-fiscal interactions and endogenous long-run growth
In a recent paper (Elfsbacka-Schmöller and McClung 2023), we show that accounting for adjustments through technological innovation via R&D and long-term growth has crucial implications for debt sustainability, price stability, and ultimately the interaction between monetary and fiscal policy. We introduce research and development (R&D) and technological innovation in the spirit of Romer (1990) into an otherwise standard model of monetary-fiscal interactions (see Leeper 1991, Woodford 1996, Cochrane 2023, and Queralto 2022 for related frameworks). In this setting, monetary and fiscal policy affect demand, higher demand encourages entrepreneurs to create new technologies, and innovations raise the long-run economic growth path. Innovation creates a feedback between current demand and long-term aggregate supply, consistent with empirical evidence (see, for instance, Ma and Zimmermann 2023, Ilzetzki 2023, Antolin-Diaz and Surico 2022). This channel has important implications for how governments and central banks can manage prices and debt levels.
Growth creates fiscal capacity
Fiscally unfunded deficits can expand technology growth, which creates endogenous fiscal capacity. This occurs through the following mechanism: when the government creates debt that it does not intend to repay with future surpluses, bondholders perceive this as an increase in their net wealth and their demand increases. This increased demand encourages entrepreneurs to invest in innovation through R&D. Increased R&D causes technological progress, which raises long-term economic growth. Faster growth, in turn, expands the long-run output trend and creates fiscal capacity, which helps governments pay off the initial debt. This means that a fiscal deficit might partially ‘pay for itself’ through growth, rather than just causing inflation. 1
Growth weakens the link between deficits and inflation
According to conventional wisdom, when governments increase spending without corresponding plans to raise future fiscal revenue (‘active’ fiscal policy), inflation is the inevitable result. However, if unfunded increases in public debt stimulate innovation, this creates fiscal capacity, which can offset the inflationary pressures typically associated with active fiscal policy. In fact, an unfunded fiscal expansion might lead to deflation if innovation is very responsive to demand. Figure 1 illustrates the effects of an unfunded fiscal expansion in our model (see Elfsbacka-Schmöller and McClung 2023 for further details). The inflation response is attenuated when innovation responds to demand, relative to the standard case in which long-run growth is constant.
Figure 1 Dynamics in response to an unfunded fiscal expansion
Notes: This figure shows the dynamics in response to an unfunded fiscal expansion in a model with endogenous technology growth through R&D (red line) and in the model with constant technology growth (black line). X-axis: quarters; y-axis: percentage deviations from steady state. Based on Elfsbacka-Schmöller and McClung (2023).
Dynamics of r-g: A new rule for central banks
Technological innovation also matters for how central banks should set interest rates to stabilise inflation. To summarise these changes, in Elfsbacka-Schmöller and McClung (2023) we propose a new guideline for central banks – the ‘growth-augmented Taylor principle’. It states that instead of merely adjusting real interest rates in response to inflation, central banks should consider the gap between the real interest rate (r) and the economic growth rate (g). To maintain economic stability under a debt-stabilising fiscal policy, central banks should strive to raise this gap (r-g) in response to persistent inflation. Under a fiscal authority which does not stabilise debt, central banks can stabilise the public debt by letting r-g fall with inflation.
Relative to the standard Taylor pinciple, the growth-augmented Taylor principle calls for larger nominal interest rate hikes in response to inflation when fiscal policy is passive. Central banks must respond more aggressively to inflation in this case to rule out self-fulfilling technology booms. On the other hand, central banks do not need to lower real interest rates under a debt-destabilising fiscal policy. This is because public debt is stabilised by a mix of inflation and technology growth. Consequently, central banks can respond more aggressively to inflation than earlier research suggests.
R&D-driven growth expands both monetary and fiscal policy space
Simply put, technological innovation can be conducive to economic stability under a wider range of policy combinations. In some cases, it is possible to have a stable economy when the government is not managing its debt, and the central bank is following a more aggressive anti-inflationary interest rate policy than traditional models would recommend. This suggests that growth creates policy space for both the monetary and fiscal authority.
Figure 2 captures the key insight that R&D-driven growth allows for a wider range of monetary policy options, including those considered to be too responsive to inflation when fiscal policy is also active. In a standard model without innovation, monetary policy must be below the black line (which represents the traditional Taylor principle) when fiscal policy is active. However, in an economy with endogenous innovation, monetary policy can also operate above this line while maintaining stability. This expansion of the feasible policy space occurs because R&D-driven growth creates fiscal capacity, which helps stabilise debt and allows for a more aggressive monetary policy response to inflation and output. The increase in policy space is substantial if innovation responds strongly to demand (blue line).
Figure 2 Growth enlarges monetary and fiscal policy space
Notes: Black line: results for the framework with constant technology; endogenous technology cases for more responsive growth (blue line) and less responsive growth (green line). x-axis: quarters; y-axis: percentage deviations from steady state. Based on Elfsbacka-Schmöller and McClung (2023).
Relationship to the debate on r<g
A recent economics literature (e.g. Blanchard 2019, Bassetto and Cui 2018, Reis 2022, Mian et al. 2022) highlights the relationship between public debt sustainability and long-term growth: when real interest rates range below the long-run growth rate (r<g), the level of primary surpluses needed to sustain a given public debt level is reduced and debt sustainability is improved. While closely linked, the channel discussed in this column is not based on such a fiscal free lunch. Instead, we show that when interest rates exceed growth rates (r>g), higher growth through R&D makes sustaining unfunded fiscal deficits easier. This suggests that monetary and fiscal policy should engineer the appropriate changes in r-g to dynamically stabilise inflation and debt. Policymakers should account for both the dynamics of real interest rates and growth when making policy decisions, as focusing solely on interest rates may lead to misjudgements of monetary and fiscal policy space or expose the economy to instability.
Why growth matters for public debt sustainability and price stability
This column discusses how conventional insights on the interaction between monetary and fiscal policy depend on the assumption of constant long-run growth. We show that when accounting for endogenous growth through technological progress via R&D, changes in demand affect the long-run output path with the following key implications for monetary-fiscal interactions:
- Fiscally unfunded deficits are less inflationary than previously suggested, as growth acts as a self-financing channel for public debt.
- Central banks should focus on the dynamics of r-g, i.e. the adjustment of the real interest rate (r) relative to the growth rate (g).
- Growth generates fiscal capacity and gives both governments and central banks more space to manoeuvre without jeopardising stable inflation or sustainable public debt.
In conclusion, accounting for long-term economic growth provides novel insights into monetary-fiscal interactions. It suggests that the interplay between public debt and monetary policy is more complex due to the effect that movements in aggregate demand exert on R&D and technology growth. These insights open up new avenues for thinking about the interaction of prices, debt, growth, and monetary and fiscal policy.
Source : VOXeu
