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"Unfunded Liabilities" and
Uncertain Fiscal Financing
Troy Davig, Eric M. Leeper, and Todd B. Walker
March 2010
RWP 10-09
Research Division
Federal Reserve Bank of Kansas City
Abstract
A rational expectations framework is developed to study the consequences
of alternative means to resolve the "unfunded liabilities" problem--unsustainable exponential growth in federal Social Security,
Medicare, and Medicaid spending with no plan to finance it. Resolution
requires specifying a probability distribution for how and when monetary
and fiscal policies will change as the economy evolves through the 21st
century. Beliefs based on that distribution determine the existence of
and the nature of equilibrium. We consider policies that in expectation
combine reaching a fiscal limit, some distorting taxation, modest
inflation, and some reneging on the government's promised transfers. In
the equilibrium, inflation-targeting monetary policy cannot successfully
anchor expected inflation. Expectational effects are always present, but
need not have large impacts on inflation and interest rates in the short
and medium runs. |
