inflation. intuitively, the logic of the fiscal theory can be described as follows : let us assume additional expenditure, for instance higher transfers, which are not financed by additional taxes but by issuing additional bonds. consequently the value of real debt is now higher than the present value of future tax payments. households feel richer and thus consume more, causing output and inflation to increase. monetary policy has to stabilise real debt to avoid an inflation spiral, with the result that it responds at a rate of less than 1 to 1 to inflation, thereby violating the taylor principle. thus, higher inflation reduces debt in real terms and lower real interest rates reduce the real debt service burden of existing government debt. in each of the two cases, a regime of fiscal dominance is characterised by higher inflation and probably also more volatile inflation. monetary policy is no longer able to control the inflation rate, and therefore welfare losses will occur. however, the story does not end here. remaining within the world of theory, we can continue as follows : because economic agents are forward - looking, it is quite possible that the consequences i have just described could manifest themselves before the economy has entered the regime of fiscal dominance. looking ahead, public debt cannot be accumulated forever. sooner or later, governments that run large deficits for a long period of time risk hitting a fiscal limit – a point at which government revenues can no longer be increased to stabilise government debt. this inability to raise revenues might have economic reasons, such as a crossing of the peak of the laffer curve. but there might also be political reasons that make it infeasible to raise taxes. certainly, the actual fiscal limit is highly uncertain in many ways : it is a probability distribution rather than a point and depends on expectations, shocks and policy measures taken. [ 5 ] and forward - looking agents know : once the government hits the fiscal limit, either an adjustment of fiscal spending or an adjustment of monetary policy needs to occur. otherwise debt cannot be stabilised. and as a consequence, monetary policy might come under pressure to step in and stabilise government debt. thus, even if fiscal policy has not yet reached its limit, the economic mechanisms attached to the fiscal theory of the price level might already swing into action. to be specific : let us assume that agents expect, with some probability, that monetary policy will bear the burden of adjustment and stabilise real government debt through higher inflation. once inflation expectations start rising, the same might happen with inflation

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