Fiscal Foundations of Inflation: Imperfect Knowledge

This paper proposes a theory of the fiscal foundations of inflation based on imperfect
knowledge and learning. Because imperfect knowledge breaks Ricardian equivalence
the scale and composition of the public debt matter for inflation. High moderate-duration
debt generates wealth effects on consumption demand that impairs the intertemporal
substitution channel of monetary policy: aggressive monetary policy is required to anchor
inflation expectations. Counterfactual experiments, in an estimated medium-scale DSGE
model, reveal the US economy would have been substantially more volatile over the
Great Inflation and Great Moderation periods, had average debt been consistent with
levels currently observed in Italy or Japan.