"Unfunded liabilities" and uncertain fiscal financing

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 a large impacts on inflation and interest rates in the short and medium runs. (C) 2010 Elsevier B.V. All rights reserved.