Impact of Inflation Target on Public Debt: A DSGE Analysis of Pakistan

Abstract

Many contemporary studies have confirmed that whenever the central bank raises the inflation target by a small amount, the real value of the public debt falls. This has been analyzed in the New Keynesian Framework. The present study, in a counterfactual fashion, tries to validate this conjecture for Pakistan. The maturity structure of public debt and imperfectly observed inflation target are incorporated in the model. The study finds that in response to a debt shock, that leads public debt to rise above the steady stat level, the central bank sets monetary policy by raising inflation target which in turn significantly decrease the real value of public debt. The impact is rather severe when economic agents have imperfect information regarding the central bank’s policy intervention. On the other hand, the impact of a higher inflation target on the value of real debt comes out to be inconsequential whenever agents have complete knowledge of monetary policy.