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

  • Stehn, Sven Jari
  • Vines, David

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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