Macroeconomics Seminar Series - Tommy Iao (Reserve Bank of Australia)

Title: Fiscal Dominance Risk according to HANK

Abstract: This paper studies the aggregate consequences of fiscal dominance risk in a heterogeneous-agent New Keynesian (HANK) model with stochastic regime transitions. Following a deficit-financed transfer, the prospect of a future fiscal-dominant regime generates a debt-inflation spiral through the interaction of inflation expectations, monetary policy, and the government budget constraint. Because households are non-Ricardian, the resulting persistence of government debt endogenously raises the natural rate of interest, amplifying the effects of fiscal dominance risk. I characterize this natural-rate channel analytically in a tractable environment and use a quantitative model to assess the contribution of pandemic-era fiscal stimulus to the post-pandemic rise in U.S. Treasury yields and the natural rate of interest. While optimal monetary policy accommodates fiscal deficits by lowering interest rates regardless of household heterogeneity, the natural-rate channel leads to markedly different optimal long-run real-rate paths across models.