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Public Debt, Distortionary Taxation, and Monetary Policy

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Since Leeper’s (1991, Journal of Monetary Economics 27, 129-147) seminal paper, an extensive literature has argued that if fiscal policy is passive, i.e., guarantees public debt stabilization irrespectively of the inflation path, monetary policy can independently be committed to inflation targeting. This can be pursued by following the Taylor principle, i.e., responding to upward perturbations in inflation with a more than one-for-one increase in the nominal interest rate. This paper analyzes an optimizing framework in which the government can only finance public expenditures by levying distortionary taxes. It is demonstrated that households’ market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate.

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Bibliographic Info

Paper provided by Tor Vergata University, CEIS in its series CEIS Research Paper with number 220.

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Length: 37 pages
Date of creation: 07 Feb 2012
Date of revision: 07 Feb 2012
Handle: RePEc:rtv:ceisrp:220

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Postal: CEIS - Centre for Economic and International Studies - Faculty of Economics - University of Rome "Tor Vergata" - Via Columbia, 2 00133 Roma
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Keywords: Public Debt; Distortionary Taxation; Monetary and Fiscal Policy Rules.;

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References

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  1. Leith, Campbell & von Thadden, Leopold, 2006. "Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers," Discussion Paper Series 1: Economic Studies 2006,21, Deutsche Bundesbank, Research Centre.
  2. Schmitt-Grohe, Stephanie & Uribe, Martin, 2007. "Optimal simple and implementable monetary and fiscal rules," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1702-1725, September.
  3. Cochrane, John H., 2005. "Money as stock," Journal of Monetary Economics, Elsevier, vol. 52(3), pages 501-528, April.
  4. Michael Woodford, 1995. "Price Level Determinacy Without Control of a Monetary Aggregate," NBER Working Papers 5204, National Bureau of Economic Research, Inc.
  5. John H. Cochrane, 2010. "Understanding Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic," NBER Working Papers 16087, National Bureau of Economic Research, Inc.
  6. Eric M. Leeper & Tack Yun, 2005. "Monetary-Fiscal Policy Interactions and the Price Level: Background and Beyond," NBER Working Papers 11646, National Bureau of Economic Research, Inc.
  7. Jean-Pascal Bénassy, 2007. "Money, Interest, and Policy: Dynamic General Equilibrium in a Non-Ricardian World," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262026139, December.
  8. Stephanie Schmitt-Grohe & Martin Uribe, 1995. "Balanced-budget rules, distortionary taxes, and aggregate instability," Finance and Economics Discussion Series 95-44, Board of Governors of the Federal Reserve System (U.S.).
  9. Todd Walker & Eric Leeper & Troy Davig, 2010. "Inflation and the Fiscal Limit," 2010 Meeting Papers 837, Society for Economic Dynamics.
  10. Rochelle M. Edge & Jeremy B. Rudd, 2002. "Taxation and the Taylor principle," Finance and Economics Discussion Series 2002-51, Board of Governors of the Federal Reserve System (U.S.).
  11. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  12. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  13. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, vol. 4(3), pages 345-80.
  14. Edge, Rochelle M. & Rudd, Jeremy B., 2007. "Taxation and the Taylor principle," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2554-2567, November.
  15. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  16. Linnemann, Ludger, 2006. "Interest rate policy, debt, and indeterminacy with distortionary taxation," Journal of Economic Dynamics and Control, Elsevier, vol. 30(3), pages 487-510, March.
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Cited by:
  1. Cochrane, John H., 2011. "Understanding policy in the great recession: Some unpleasant fiscal arithmetic," European Economic Review, Elsevier, vol. 55(1), pages 2-30, January.

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