Oliver Pfäuti, University of Texas at Austin

"Public Debt and the Price of Fiscal Uncertainty: Attention and Inflation Volatility"

Abstract

How does public debt shape inflation when firms are imperfectly informed about fiscal conditions and macroeconomic shocks? We study this question in a general equilibrium model of rationally inattentive price setting, where fiscal policy affects firms’ desired prices through taxes on firm revenues. Public debt changes firms’ incentives to acquire information through two opposing forces: higher debt lowers the stakes of pricing decisions, while making desired prices more sensitive to tax changes. This trade-off generates a U-shape in both firms' attention and passthrough with respect to public debt. We test this prediction using micro data on price-setting by firms in 12 Euro Area countries. The implied passthrough of cost shocks declines with debt at low debt levels, reaches a minimum around a debt-to-GDP ratio of 80%, and rises thereafter. Endogenous attention makes the inflationary effects of fiscal policy state dependent. Faster debt repayment lowers attention and inflation volatility when debt is low, but raises both when debt is high. Fiscal shocks under elevated prior uncertainty generate substantially larger inflation responses at high debt, while leaving inflation dynamics nearly unchanged at low debt.

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