Alberto Ramirez de Aguilar

Debt, Inflation, and Government Reputation

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. I propose a dynamic game model with incomplete information where private agents (wage setters) and a consolidated government (a player taking fiscal and monetary policy decisions) interact over time. The government's type is private information, and wage setters learn the type of the government through the observed history of implemented policies. 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 the government's 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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