Monetary policy near fiscal limit sparks inflation-output tradeoff revelation.
The article explores how changes in debt levels affect the impact of monetary policy on inflation and output. The type of monetary policy rule used by the central bank is crucial. When targeting the risky rate, a temporary monetary contraction leads to higher inflation. In contrast, targeting the risk-free rate leads to lower inflation but prolonged output contraction. This highlights the tradeoff between stabilizing inflation and output when sovereign default risk is high.