European Central Bank working paper finds price stability with non Ricardian households hinges on a debt to GDP ceiling and a policy rate response to public debt

The European Central Bank published a Working Paper by Stéphane Dupraz and Anna Rogantini Picco analysing what fiscal conditions are required for monetary policy to maintain price stability when households are not Ricardian. The paper argues that, in this setting, the key fiscal requirement is an upper limit on the real debt to GDP ratio, and that implementing a stable price equilibrium may require monetary policy to react to the level of public debt rather than to inflation alone. In contrast to the Fiscal Theory of the Price Level result that stable prices require government debt to be backed by the net present value of future fiscal surpluses, the paper finds that households’ intertemporal budget constraints impose only weak restrictions when households are non Ricardian. Instead, high public debt raises aggregate demand via a wealth effect; beyond a threshold debt to GDP level, even arbitrarily large interest rate hikes cannot offset this demand pressure, so no stable price equilibrium exists and inflation must erode the real value of debt. Using a perpetual youth model and a two generation overlapping generations model, the paper also shows that under a standard Taylor rule that responds only to inflation, fiscal shocks affect inflation even with strong monetary tightening, while adding a direct response to public debt can restore insulation of inflation from fiscal shocks. Quantitatively, the estimated debt to GDP ceiling is model dependent and often very high, reported as about 1600 times GDP under an overlapping generations calibration and around 10 times GDP under a HANK style interpretation. The paper is published as research and does not represent the views of the European Central Bank.