Debt Stabilization Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence

Abstract

This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.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 shockand 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. JEL Classification Numbers: E52, E60, E61, E63

Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy

“…Finally, several studies have characterized optimal monetary and fiscal policy in New Keynesian models that account for the presence of government debt but abstract from the zero bound on nominal interest rates. Wren- Lewis and Leith (2007) and Vines and Stehn (2007) characterize the optimal policy mix under discretion, whereas Schmitt-Grohe and Uribe (2004) and Adam (2011) analyse optimal commitment policies. The remainder of the paper is organized as follows.…”