Monetary Policy and Government Debt

We study how the level of government debt affects the effectiveness of monetary policy, that is, the elasticity of economic aggregates to interest rate changes. We build a New Keynesian model where fiscal policy is non-Ricardian and government debt is risk-free. Wealth effects generated by government bonds weaken the transmission of monetary policy to output. Using data on private ownership of U.S. public debt, we find that when the debt-to-GDP ratio is one standard deviation above its mean, the response of industrial production and unemployment to a monetary shock decreases by 0.75pp and 0.1pp, respectively, out to a 3-year horizon.