Can passive monetary policy decrease the debt burden?

Abstract

Large expansionary fiscal measures are often implemented with monetary accommodation during an economic crisis. When a government is highly indebted, and the timing of switching to the conventional regime $M$ (passive fiscal/active monetary policies) is uncertain, a government spending increase in regime $F$ (active fiscal/passive monetary policies) increases government debt. Such regime uncertainty dampens inflation and debt revaluation effects. Also, as regime uncertainty generates a smaller real interest rate decline, debt servicing costs fall less, and tax revenues increase less, than in the fixed regime $F$. These factors contribute to reversing the debt decline for a spending increase in the fixed regime $F$. The result holds under adverse supply shocks and potentially higher capital taxes, relevant factors in the post-COVID U.S. economy.