In the evolving landscape of macroeconomic policymaking, the interaction between monetary and fiscal policy has become increasingly critical – especially in the context of rising global debt, persistent inflation, and tightening financial conditions. The paper titled “The Effects of Monetary Policy Shocks on Inflation: The Role of Backed and Unbacked Public Debt in a Monetary and Fiscal Policy Regime Mix” provides valuable insight into how monetary policy transmits to inflation through its interaction with different types of public debt and fiscal commitments.
Theoretical Framework and Regimes
The paper builds on the fiscal theory of the price level (FTPL), which recognises that inflation can be driven not only by monetary policy but also by fiscal imbalances – particularly when public debt is not fully backed by future fiscal surpluses.
Traditional models typically analyse two regimes. The first one is Regime M (Monetary dominance): The central bank controls inflation while the fiscal authority adjusts surpluses to stabilise public debt. The second regime is Regime F (Fiscal dominance): The fiscal authority determines the path of public debt without committing to debt stabilisation, leaving the central bank to accommodate the fiscal authority’s policy stance and does not control inflation.
However, these two extremes often fail to reflect real-world complexities. As a middle-ground alternative, the study investigates a coexistence regime, where public debt is split into backed and unbacked components. Backed debt is expected to be repaid through future fiscal surpluses (Regime M), while unbacked debt is stabilised via inflation (Regime F).
Key Findings
We simulate how a contractionary monetary policy shock affects inflation and debt dynamics under the three regimes. Under the coexistence regime, inflation rises less than under Regime F and public debt increases less than under Regime M. This outcome results from a balanced response: some debt is absorbed through modest fiscal surpluses while the remaining debt is stabilised by inflation.
This policy mix dampens the adverse trade-offs seen in the two extremes. For instance, in Regime M, inflation falls sharply after a monetary shock, but public debt increases unsustainably due to higher real interest payments. In Regime F, inflation surges due to higher household wealth expectations and the absence of fiscal adjustment, but this comes at a cost of macroeconomic instability.
An important result is the trade-off between stabilising inflation and public debt. Using efficient policy frontier (EPF) analysis, the paper shows that when a large share of monetary policy shocks influences unbacked debt (i.e., the fiscal component), policymakers face higher volatility in both inflation and debt. However, if the share of unbacked debt affected by monetary shocks is limited (e.g., 25%), this trade-off nearly vanishes, suggesting that precise calibration of policy responses can minimise macroeconomic volatility.
The study finds that under sticky prices – common in the real world – contractionary monetary policy shocks have a slower and weaker effect on inflation. This raises debt servicing costs more sharply, particularly for unbacked debt, and results in higher public debt accumulation. In contrast, under more flexible prices, inflation responds faster, easing the debt burden via erosion of real debt values.
Lastly, the study quantifies welfare using a consumption-equivalent metric. The coexistence regime results in 1.3% higher welfare compared to Regime M, while Regime F leads to a 2.3% welfare loss. This indicates that balanced coordination – not dominance by either fiscal or monetary policy – produces the most favorable macroeconomic and welfare outcomes.
Policy Implications
The findings underscore the inadequacy of relying solely on either monetary or fiscal policy in times of high debt and inflation. Instead, a balanced coordination between the two, as exemplified by the coexistence regime, emerges as a superior framework for managing macroeconomic trade-offs.
Policymakers should consider (1) The composition of debt: Understanding the share of backed vs unbacked debt is vital in crafting a suitable response to monetary policy shocks; (2) Interest rate paths: In a high-rate environment, unbacked debt imposes larger fiscal pressures due to rising debt service costs; (3) Expectations management: Inflation expectations, influenced by perceived fiscal commitments, can either reinforce or mute monetary policy effectiveness.
Conclusion
The paper presents compelling evidence for integrating a hybrid policy framework where both fiscal and monetary authorities share the burden of stabilisation. This approach is not only more realistic but also welfare-enhancing, particularly in an era of elevated debt, tightening global monetary conditions, and constrained fiscal space. By recognising the distinct effects of backed and unbacked debt, the study offers a nuanced policy blueprint to guide macroeconomic management in turbulent times.
Since the 2008 global financial crisis, South Africa has experienced steadily increasing debt burden – debt-to-GDP ratio reached 77% in 2024 from 27% in 2008. The associated debt service cost has followed the same path, not only because of the persistent increases in the total outstanding public debt, but also higher interest rates. The country has also experienced persistent primary budget deficits and low economic growth since the financial crisis. Given the South Africa’s current macroeconomic landscape, it is critical that the monetary and fiscal authorities coordinate with each other, opting for a balanced approach, such as the coexistence regime, to achieve balanced debt and price stability.
The recent Medium-Term Budget Policy Statement released in November 2025 reinforces the study’s key findings: with a lower inflation target and a firm commitment to fiscal sustainability, the SARB and the National Treasury should be able to coordinate effectively to achieve macroeconomic and financial stability.
