Fiscal Dominance Risk According to HANK

Abstract

I study the aggregate consequences of fiscal dominance risk in heterogeneous-agent economies with non-Ricardian households. I develop a regime-switching HANK model featuring a monetary-led regime and a fiscal-dominant regime, and contrast its dynamics with those of RANK in response to a deficit-financed fiscal stimulus shock. In both models, the risk of fiscal dominance raises inflation expectations, prompting a monetary tightening. In RANK, the higher real interest rate persistently depresses the output through the intertemporal substitution channel. In HANK, this contractionary effect is offset by an endogenously higher natural rate of interest, allowing the output to return to the steady state despite persistent inflation and elevated interest rates. Optimal output-inflation tradeoff requires a slow monetary reaction to inflation, regardless of heterogeneity. I further discuss the robustness of the results to the slope of the Phillips curve and the monetary policy rule.