Discussion Paper Details

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Title: Optimal Monetary and Fiscal Policy in an Economy with Endogenous Public Debt

Author(s): Paul Luk and David Vines

Publication Date: May 2015

Keyword(s): fiscal policy, government debt, monetary policy and New Keynesian model

Programme Area(s): International Macroeconomics

Abstract: This paper uses a New Keynesian framework to study the coordination of fiscal and monetary policies, in response to an inflation shock when the policymaker acts with commitment. We first show that, in the simplest New Keynesian model, fiscal policy plays no part in the optimal policy response, because of the comparative advantage which monetary policy has in the control of inflation. We then add endogenous public debt and show that the above result is no longer true. When the initial stock of debt is low, it is optimal for government spending to remain largely inactive, but when the initial stock of debt is high, government spending should play a significant stabilisation role in the first period. This finding is robust to adding endogenous capital accumulation and inflation persistence in the Phillips curve.

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Bibliographic Reference

Luk, P and Vines, D. 2015. 'Optimal Monetary and Fiscal Policy in an Economy with Endogenous Public Debt'. London, Centre for Economic Policy Research.