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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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  • Svan Jari Stehn

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  • David Vines

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    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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    Bibliographic Info

    Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2007-22.

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    Length: 35 pages
    Date of creation: Oct 2007
    Date of revision:
    Handle: RePEc:een:camaaa:2007-22

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