Debt Stabilization Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence
International Monetary Fund, Aug 1, 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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control of inflation cost-push shock Currie and Levine cut debt debt control debt economy B I debt stabilisation bias debt stock debt to output debt under optimal deﬁne economy B I 0.4 excess loss ﬁrst order conditions ﬁrst period ﬁscal feedback ﬁscal policy follow a random forward-looking high debt economy hybrid Phillips curve incentive to renege inconsistent inﬂation 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 marginal cost maximum eigenvalue monetary and ﬁscal monetary policy nominal interest rate non-predetermined variables optimal commitment policy optimal discretionary policy Optimal Fiscal optimal ﬁscal policy optimal policy policy under commitment policy under discretion policymaker predetermined variables public debt random walk ratio of debt reduce debt rule-of-thumb price setters social welfare function steady-state consumption steady-state debt steady-state ratio Steinsson 2003 Taylor principle time-inconsistent violate the Taylor Zero