DP6696 Debt Stabilisation Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence

Author(s): Sven Jari Stehn, David Vines
Publication Date: February 2008
Keyword(s): Fiscal Policy, Government Debt, Monetary Policy, Stabilisation Bias
JEL(s): E52, E60, E61, E63
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6696

Leith and Wren-Lewis (2007) have shown that government debt is returned to its pre-shock level in a New Keynesian model under optimal discretionary policy. This has two important implications for monetary and fiscal policy. First, in a high-debt economy, it may be optimal for discretionary monetary policy to cut the interest rate in response to a cost-push shock - thereby violating the Taylor principle - although this will not be true if inflation is significantly persistent. Second, the optimal fiscal response to such a shock is more active under discretion than commitment, whatever the degree of inflation persistence.