IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

Fiscal Sustainability in a New Keynesian Model

  • CAMPBELL LEITH
  • SIMON WREN‐LEWIS

There has been a wealth of recent work deriving optimal monetary policy utilising New Neo-Classical Synthesis (NNCS) models based on nominal inertia. Such models typically abstract from the impact of monetary policy on the government’s finances, by assuming that consumers are infinitely-lived and taxes are lump-sum such that Ricardian Equivalence holds. In this paper, in the context of a sticky-price NNCS model, we assume that the government must adjust spending and/or distortionary taxation to satisfy its intertemporal budget constraint. We then consider optimal monetary and fiscal policies under discretion and commitment in the face of technology, preference and cost-push shocks. We find that the optimal precommitment policy implies a random walk in the steady-state level of debt, generalising earlier results that involved only a single fiscal instrument. In the case of negative fiscal shocks this implies permanently higher taxation and lower output and government spending to support the new steady-state debt stock, but the optimal combination of these variables will ensure a zero rate of inflation under commitment. We also find that the time-inconsistency in the optimal precommitment policy is such that governments are tempted, given inflationary expectations, to raise taxation to reduce the ultimate debt burden they need to service. Since taxation is a distortionary labour income tax, this aggressive raising of taxation raises firms’ marginal costs and fuels inflation. We show that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original, first-best, debt level. This implies that under discretionary policy the random walk result is overturned: debt will always be returned to this initial steady-state even although there is no explicit debt target in the government’s objective function. In a series of numerical simulations we show that the welfare consequences of introducing debt are negligible for precommitment p

(This abstract was borrowed from another version of this item.)

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://hdl.handle.net/10.1111/
Download Restriction: Access to full text is restricted to subscribers.

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 45 (2013)
Issue (Month): 8 (December)
Pages: 1477-1516

as
in new window

Handle: RePEc:mcb:jmoncb:v:45:y:2013:i:8:p:1477-1516
Contact details of provider: Web page: http://www.blackwellpublishing.com/journal.asp?ref=0022-2879

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Leith, Campbell & Wren-Lewis, Simon, 2000. "Interactions between Monetary and Fiscal Policy Rules," Economic Journal, Royal Economic Society, vol. 110(462), pages C93-108, March.
  2. Leith, Campbell & Simon Wren-Lewis, 2002. "Compatibility Between Monetary and Fiscal Policy Under EMU," Royal Economic Society Annual Conference 2002 124, Royal Economic Society.
  3. Pierpaolo Benigno & Michael Woodford, 2004. "Optimal monetary and fiscal policy: a linear-quadratic approach," International Finance Discussion Papers 806, Board of Governors of the Federal Reserve System (U.S.).
  4. Campbell Leith & Simon Wren-lewis, 2006. "The Costs of Fiscal Inflexibility," WEF Working Papers 0005, ESRC World Economy and Finance Research Programme, Birkbeck, University of London.
  5. Maurice Obstfeld, 1989. "Dynamic Seigniorage Theory: An Exploration," NBER Working Papers 2869, National Bureau of Economic Research, Inc.
  6. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, pages 519-546.
  7. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April.
  8. Campbell leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," Working Papers 2001_16, Business School - Economics, University of Glasgow.
  9. Beetsma, Roel & Jensen, Henrik, 2003. "Mark-Up Fluctuations and Fiscal Policy Stabilization in a Monetary Union," CEPR Discussion Papers 4020, C.E.P.R. Discussion Papers.
  10. Ellison, Martin & Rankin, Neil, 2007. "Optimal monetary policy when lump-sum taxes are unavailable: A reconsideration of the outcomes under commitment and discretion," Journal of Economic Dynamics and Control, Elsevier, vol. 31(1), pages 219-243, January.
  11. Bernheim, B Douglas, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 540-42, August.
  12. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  13. Peter N. Ireland, 2002. "Technology Shocks in the New Keynesian Model," Boston College Working Papers in Economics 536, Boston College Department of Economics.
  14. Smets, Frank & Wouters, Raf, 2004. "Comparing shocks and frictions in US and euro area business cycles: a Bayesian DSGE approach," Working Paper Series 0391, European Central Bank.
  15. Lombardo, Giovanni & Sutherland, Alan, 2004. "Monetary and fiscal interactions in open economies," Journal of Macroeconomics, Elsevier, vol. 26(2), pages 319-347, June.
  16. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  17. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
  18. Obstfeld, Maurice, 1997. "Dynamic Seigniorage Theory," Macroeconomic Dynamics, Cambridge University Press, vol. 1(03), pages 588-614, September.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:mcb:jmoncb:v:45:y:2013:i:8:p:1477-1516. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Wiley-Blackwell Digital Licensing)

or (Christopher F. Baum)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.