Regional debt in monetary unions: Is it inflationary?

Russell Cooper, Hubert Kempf, Dan Peled

Research output: Contribution to journalArticlepeer-review

11 Scopus citations

Abstract

This paper studies the inflationary implications of interest bearing regional debt in a monetary union. Is this debt simply backed by future taxation with no inflationary consequences? Or will the circulation of region debt induce monetization by a central bank? We argue here that both outcomes can arise in equilibrium. In the model economy, there are multiple equilibria which reflect the perceptions of agents regarding the manner in which the debt obligations will be met. In one equilibrium, termed Ricardian, the future obligations are met with taxation by a regional government while in the other, termed Monetization, the central bank is induced to print money to finance the region's obligations. The multiplicity of equilibria reflects a commitment problem of the central bank. A key indicator of the selected equilibrium is the distribution of regional debt holdings. We show that regional governments, anticipating central bank financing of their debt obligations, have an incentive to create excessively large deficits. We use the model to assess the impact of some policy measures within a monetary union as well as dollarization.

Original languageEnglish (US)
Pages (from-to)345-358
Number of pages14
JournalEuropean Economic Review
Volume54
Issue number3
DOIs
StatePublished - Apr 2010

All Science Journal Classification (ASJC) codes

  • Finance
  • Economics and Econometrics

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