The perils of narrowing fiscal spaces

by Hanno Kase, Leonardo Melosi, Sebastian Rast, Matthias Rottner<br />When public debt is elevated, the fiscal cost of fighting inflation rises sharply, as interest rate hikes increase government interest expenditures. We formalize this mechanism in a nonlinear New Keynesian model with a state-dependent fiscal constraint on monetary policy. High debt may dampen the monetary response to inflation, generating an …