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Inflation's Role in Optimal Monetary-Fiscal Policy

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  • Eric M. Leeper
  • Xuan Zhou

Abstract

We study how the maturity structure of nominal government debt affects optimal monetary and fiscal policy decisions and equilibrium outcomes in the presence of distortionary taxes and sticky prices. Key findings are: (1) there is always a role for current and future inflation innovations to revalue government debt, reducing reliance on distorting taxes; (2) the role of inflation in optimal fiscal financing increases with the average maturity of government debt; (3) as average maturity rises, it is optimal to tradeoff inflation for output stabilization; (4) inflation is relatively more important as a fiscal shock absorber in high-debt than in low-debt economies; (5) in some calibrations that are relevant to U.S. data, welfare under the fully optimal monetary and fiscal policies can be made equivalent to the welfare under the conventional optimal monetary policy with passively adjusting lump-sum taxes by extending the average maturity of bond.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19686.

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Date of creation: Nov 2013
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Handle: RePEc:nbr:nberwo:19686

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  1. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, American Economic Association, vol. 80(5), pages 1217-30, December.
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Cited by:
  1. Jens Hilscher & Alon Raviv & Ricardo Reis, 2014. "Inflating Away the Public Debt? An Empirical Assessment," Working Papers, Brandeis University, Department of Economics and International Businesss School 74, Brandeis University, Department of Economics and International Businesss School.

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