Fiscal Sustainability in a New Keynesian Model

Abstract

Fiscal Sustainability in a New Keynesian ModelRecent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady-state debt to follow a random walk. In this paper we consider the nature of the time inconsistency involved in such a policy and its implication for discretionary policymaking. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government's objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi-commitment policy, which allows for different probabilities of reneging on past promises. JEL codes: E62, E63Keywords: New Keynesian model, government debt, monetary policy, fiscal policy, credibility.IN STICKY-PRICE NEW KEYNESIAN models where social welfare is derived from consumers' utility, Benigno and Woodford (2003) and SchmittGrohe and Uribe (2004) show that optimal steady-state debt follows a random walk when policymakers can commit to a time-inconsistent monetary and fiscal policy. In this paper we analyze the nature of the time inconsistency involved and show thatWe would like to thank the editor, Paul Evans, three anonymous referees, Javier Andres, Florin Bilbiie, Tatiana Kirsanova, Luisa Lambertini, Ioana Moldovan, Raffaele Rossi, Martin Uribe, and participants at seminars at the Universities of Oxford and Valencia and the Bank of Spain for very helpful comments. We would also like to thank Tatiana Kirsanova and Christoph Himmels for providing us with computer code to facilitate the solution of the model under quasi-commitment. All errors remain our own. We are also grateful to the ESRC, grant nos. RES-156-25-003 and RES-062-23-1436, for financial assistance.

What should fiscal councils do?

“…Leith and Wren-Lewis (2007) show that the time-consistent optimal debt policy can involve a rapid return to a debt target in a model with sticky prices or nominal debt. 7 Even in the standard Ricardian case, the welfare of future generations will still be discounted, which may not be ethically desirable (Stern, 2006).…”

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

“…Following on from this, Leith and Wren-Lewis (2007) show that the means of adjustment of debt to its initial value depends crucially on the steady-state ratio of debt to output (because this determines the relative e¤ectiveness of monetary and …scal policy in controlling debt). With a low steady-state value of debt, the burden of adjustment is shared by …scal and monetary policy.…”

“…Previously, a number of studies had analysed responses to shocks in such models with optimal monetary and …scal policy under the commitment. These papers show that government debt under optimal commitment policy follows a random walk (Benigno and Woodford 2003, Schmitt-Grohe and Uribe 2004, Leith and Wren-Lewis 2007. With permanently higher debt, there will be permanently higher interest payments, and thus there will need to be a permanently lower level of public expenditure.…”

“…But this is optimal because the current-period costs, to both in ‡ation and public spending, of reducing the debt stock back to its original level outweigh the discounted costs of the permanently lower public expenditure. Recently, Leith and Wren-Lewis (2007), have shown that such behaviour for debt is time inconsistent 4 . This is because, when debt is above its original level, the policymaker faces an incentive to reduce debt slightly in the …rst period.…”

How to restore sustainability of the euro?

“…by Leith and Wren-Lewis (2007) in an optimising framework with several instruments of fiscal policy identified in it, see also Galí andMonacelli (2008), Ferrero (2008) and Orjasniemi (2010). Here our approach deviates from these optimal policy analyses in a fundamental way.…”