Debt, Inflation, And Government Reputation
Job Market Paper
Abstract This paper develops a theoretical framework to explain the correlation between public debt and inflation through different episodes, focusing on the role of government reputation (defined as the public's belief in the government's commitment to low inflation) in shaping inflation expectations. Many countries, particularly in Latin America, have experienced periods of high inflation driven by elevated public debt and fiscal deficits. While independent monetary authorities and inflation targeting have weakened the historical link between debt and inflation, concerns persist that high debt could still trigger inflation. I propose a dynamic game model with incomplete information where private agents (wage setters) and a consolidated government interact over time. The government can be either prudent, prioritizing low inflation, or imprudent, favoring short-term output and debt gains through higher inflation. Wage setters form inflation expectations based on the government's debt trajectory and its perceived reputation. The model implies a monotonic relationship between inflation and reputation, in the sense that higher government reputation implies lower inflation. In addition, as government reputation increases, the incidence of the current debt state on inflation is reduced. Hence, when reputation is strong, a government can sustain low inflation even with high debt. I calibrate the model using data from four emerging markets (Mexico, Colombia, Guatemala, and Thailand), illustrating how government reputation influences inflation dynamics. The findings underscore the importance of maintaining low inflation as debt rises to build and preserve government credibility, while also providing insights into the periods of high correlation between debt and inflation observed in these economies.
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