Fiscal Dominance Risk According to HANK

Abstract

This paper studies the positive and normative implications of fiscal dominance risk—the anticipated possibility of fiscal dominance—in a Heterogeneous Agent New Keynesian (HANK) framework with stochastic regime transition. I incorporate stochastic regime transition into a standard HANK model and compare its response to deficit‑financed transfers against a representative-agent (RANK) benchmark. In both models, the expectation of future fiscal dominance raises current inflation, prompting monetary tightening that increases debt‑service costs and feeds back into inflation expectations. In HANK, however, the resulting persistence of high public debt endogenously raises the natural rate of interest, altering output dynamics relative to RANK. I analytically characterize this natural‑rate channel in a simplified environment and assess its importance for the COVID stimulus in a quantitative model. When inflation stabilization is the primary objective, optimal monetary policy accommodates fiscal deficits by lowering the nominal rate, regardless of household heterogeneity, while the implications for the long-run real‑rate path differs across models.