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

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  • Stehn, Sven Jari
  • Vines, David

Abstract

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6696.

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Date of creation: Feb 2008
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Handle: RePEc:cpr:ceprdp:6696

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Keywords: Fiscal Policy; Government Debt; Monetary Policy; Stabilisation Bias;

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References

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  1. Steinsson, Jon, 2003. "Optimal monetary policy in an economy with inflation persistence," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1425-1456, October.
  2. Troy Davig & Eric M. Leeper, 2006. "Generalizing the Taylor Principle," Caepr Working Papers 2006-001, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  3. Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," CEPR Discussion Papers 4334, C.E.P.R. Discussion Papers.
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  12. Srobona Mitra, 2007. "Is the Quantity of Government Debt a Constraint for Monetary Policy?," IMF Working Papers 07/62, International Monetary Fund.
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  15. Christopher Allsopp & David Vines, 2005. "The Macroeconomic Role of Fiscal Policy," Oxford Review of Economic Policy, Oxford University Press, vol. 21(4), pages 485-508, Winter.
  16. Garima Vasishtha & Taimur Baig & Manmohan S. Kumar & Edda Zoli, 2006. "Fiscal and Monetary Nexus in Emerging Market Economies," IMF Working Papers 06/184, International Monetary Fund.
  17. Currie,David & Levine,Paul, 1993. "Rules, Reputation and Macroeconomic Policy Coordination," Cambridge Books, Cambridge University Press, number 9780521441964, April.
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  19. Nelson, Edward, 2001. "UK Monetary Policy 1972-97: A Guide Using Taylor Rules," CEPR Discussion Papers 2931, C.E.P.R. Discussion Papers.
  20. Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
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Cited by:
  1. Sven Jari Stehn & David Vines, 2008. "Strategic Interactions Between An Independent Central Bank and a Myopic Government with Government Debt," IMF Working Papers 08/164, International Monetary Fund.
  2. Tatiana Kirsanova & David Vines & Simon Wren-Lewis, 2007. "When Inflation Persistence Really Matters: Two examples," Kiel Working Papers 1351, Kiel Institute for the World Economy.

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