Introduction

Two decades ago, the Reserve Bank of New Zealand adopted a new framework for the conduct of its monetary policy, namely inflation targeting (IT). IT is mainly characterized by 5 criteria, namely (i) public announcement of a medium-term inflation target, (ii) institutional commitment to price stability as the primary goal of monetary policy, (iii) forward-looking strategy for inflation forecasts, (iv) enhanced transparency, and (v) greater accountability of central bank in achieving its inflation target (for an extensive discussion, see, e.g., Svensson, 1997; Mishkin, 2000; or Truman, 2003). Since its first adoption, the popularity of IT has grown considerably, to the point where 30 central banks use it currently as their operational framework for conducting monetary policy, and many others, especially developing countries, are planning to move towards it. This increased popularity of IT stems mainly from its alleged macroeconomic benefits. For example, IT adoption was found to bring down inflation levels and its volatility (Vega and Winkelried, 2005; Mishkin and Schmidt-Hebbel, 2007; Lin and Ye, 2009), output volatility (Levin et al., 2004; Petursson, 2005; Gonçalves and Salles, 2008), or interest and exchange rates volatility (Batini and Laxton, 2007; Rose, 2007; or Lin, 2010).

The present paper extends this literature by focusing on the linkage between IT and fiscal policy. In addition to the traditional view defending an exclusive role for monetary policy regarding inflation dynamics, an influential strand of literature, inspired by the seminal contribution of Sargent and Wallace (1981), points out that fiscal policy can equally be a source of inflation. Indeed, in a context of “fiscal dominance”, a loose fiscal policy can drive inflation because the central bank must ultimately monetize the public debt, consistently with the unpleasant monetarist arithmetic (Sargent and Wallace, 1981). An alternative rationale, which is the heart of the Fiscal Theory of the Price Level (see, e.g., Leeper, 1991; Sims, 1994; Woodford, 1995; Cochrane, 1999; Gordon and Leeper, 2005; or Sims, 2011) or more broadly of the literature on the price level determinacy (see, e.g., Aiyagari and Gertler, 1985; Sims, 1988; or Woodford, 1994), is that under fiscal dominance, newly issued nominal government bonds will cause the price level to rise to meet the government’s intertemporal budget constraint.