Debt stabilization bias and the Taylor principle: optimal policy in a New Keynesian model with government debt and inflation persistence, Issues 2007-2206
International Monetary Fund, Fiscal Affairs Dept., 2007 - Business & Economics - 52 pages
We analyse optimal monetary and fiscal policy in a New-Keynesian model with public debt and inflation persistence. Leith and Wren-Lewis (2007) have shown that optimal discretionary policy is subject to a 'debt stabilization bias' which requires debt to be returned to its pre-shock level. This finding has two important implications for optimal discretionary policy. Firstly, as Leith and Wren-Lewis have shown, optimal monetary policy in an economy with high steady-state debt cuts the interest rate in response to a cost-push shock - and therefore violates the Taylor principle. We show that this striking result is not true with high degrees of inflation persistence. Secondly, we show that optimal fiscal policy is more active under discretion than commitment at all degrees of inflation persistence and all levels of debt.
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Solving for Optimal Policy
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aggregate demand control of inflation cost-push shock current inflation Currie and Levine cut debt debt control debt stabilisation bias debt stock debt under optimal define disinflation excess loss Figure follow a random forward-looking fulfils the Taylor government spending high debt economy hybrid Phillips curve incentive to renege inconsistent inflation and debt inflation persistence inflation stabilisation bias interest payments Keynesian Phillips curve Kirsanova and Wren-Lewis Leith and Wren-Lewis level of debt linearise loss function low debt economy lower interest rates marginal cost maximum eigenvalue monetary and fiscal monetary policy nominal interest rate non-predetermined variables optimal commitment policy optimal discretionary policy optimal fiscal policy optimal policy order conditions output policy under commitment policy under discretion policymaker predetermined variables predominantly backward looking public debt random walk reduce debt rises rule-of-thumb price setters social welfare function steady-state consumption steady-state debt steady-state level steady-state value Taylor principle time-inconsistent value of debt violate the Taylor zero