Fiscal Dominance Risk According to HANK

Abstract

I study the positive and normative consequences of fiscal dominance risk—the anticipated possibility of fiscal dominance—in a HANK model with stochastic regime transition. Following a deficit-financed transfer, the expectation of future fiscal dominance raises current inflation, prompting monetary tightening that increases debt‑service costs and reinforces inflation expectations. The resulting persistence of elevated public debt endogenously raises the natural rate of interest, generating distinct output dynamics relative to a RANK benchmark. I analytically characterize this natural‑rate channel in a simplified environment and quantify its relevance for the U.S. Covid stimulus using the quantitative model. Normatively, when inflation stabilization is the primary objective, optimal monetary policy accommodates fiscal deficits by lowering the interest rate, regardless of household heterogeneity. Nonetheless, the optimal long‑run real‑rate path differs across models due to the natural-rate channel.