Fiscal Dominance, Interest Rates, and Inflation Expectations in Emerging Economies: A Fiscal-Monetary Interaction Framework
Pedro da Silva Artur
Abstract
When does an increase in the policy interest rate reduce inflation, and when can it fail to do
so? This paper revisits the question through the lens of the fiscal theory of the price level
(FTPL) and Sargent and Wallace’s classic “unpleasant monetarist arithmetic.” I develop a
compact analytical framework in which the price level is determined by the ratio of the
government’s nominal liabilities to the expected present value of primary surpluses, and in
which monetary policy affects inflation through two channels: the conventional demand-
compression channel and a fiscal debt-cost channel. I show that (i) under monetary
dominance, monetary tightening reduces inflation in the usual way; (ii) under fiscal
dominance, higher interest rates raise debt service and can increase inflation if surpluses do
not adjust; (iii) the share of debt that reprices quickly with the interest rate, expressed by a
closed-form exposure factor, determines the strength of the fiscal channel; (iv) there is a
region, in the space defined by debt exposure and the degree of fiscal backing, in which the
impact effect of tightening on inflation changes sign, a region that narrows at longer
inflation-expectation horizons when the interest-rate shock is more persistent than price
adjustment; and (v) fiscal credibility restores the conventional effect only below a critical
debt level, since no degree of belief can compensate for insufficient backing capacity. To
organize these results, I propose an integrative conceptual model, the Conditional
Transmission Circuit, which combines debt exposure, fiscal capacity and beliefs into a
transmission margin. An illustrative numerical simulation, with explicitly arbitrary
parameters, quantifies these results. The paper derives testable empirical hypotheses and
policy implications for emerging economies. It is a theoretical contribution and presents no
empirical estimates.