Events

Professor Kairong Xiao
Roger F. Murray Associate Professor of Business
Columbia Business School
Columbia University

Elevated government debt creates a fundamental dilemma for monetary policy: raising interest rates curbs private spending through intertemporal substitution, but mechanically expands scal decits, transferring net interest income to households and stimulating aggregate demand. In a New Keynesian model with non-Ricardian households, I show that when debt is modest, maturity is long, or scal backing is strong, an independent central bank can completely neutralize this scal feedback. In this neutrality regime, adjusting the policy rate path by a debt-demand correction perfectly replicates the optimal inflation and output allocations of a debt-free economy. When debt is high and reprices rapidly, however, neutrality breaks down. Setting the rate path required to preserve debt-free allocations generates interest obligations faster than scal policy can retire them, threatening debt sustainability. In this non-neutral regime, an independent central bank caring strictly about macroeconomic stabilization must accept a welfare-reducing distortion in its target variables. Optimal policy introduces a nancing correction that tempers rate hikes to contain debt-servicing feedback. Consequently, sovereign scal exposure—determined jointly by debt volume and repricing velocity governs whether government liabilities merely alter the policy rate path or fundamentally constrain macroeconomic stabilization.