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Contrary to popular belief, inflation-indexed government debt can boost inflation in response to deficit shocks, conditional on a lack of sufficient future fiscal backing. I formalize this insight through a state-of-the-art calibrated HANK model with multiple asset types, showing that the annual inflationary effect of a 1% deficit-to-GDP shock increases by 0.5 percentage points when the share of inflation-indexed debt moves from zero to levels observed in the U.K. The main mechanism is that the price level becomes partially backward-looking through the presence of inflation-indexed debt. Empirical evidence from high-powered fiscal deficit shocks supports this finding, which has additional implications for the distinction between ‘fiscally-led’ mechanisms and ‘HANK-type’ mechanisms surpassing Ricardian equivalence.
