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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
Date of revision:
Handle: RePEc:cpr:ceprdp:6696
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  1. Campbell Leith & Simon Wren-Lewis, 2006. "Fiscal Sustainability in a New Keynesian Model," Working Papers 2006_11, Business School - Economics, University of Glasgow, revised Nov 2008.
  2. Jordi Galí & J. David López-Salido & Javier Vallés, 2007. "Understanding the Effects of Government Spending on Consumption," Journal of the European Economic Association, MIT Press, vol. 5(1), pages 227-270, 03.
  3. Tatiana Kirsanova & Simon Wren-Lewis, 2007. "Optimal fiscal feedback on debt in an economy with nominal rigidities," FRB Atlanta Working Paper No. 2007-26, Federal Reserve Bank of Atlanta.
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  14. Pierpaolo Benigno & Michael Woodford, 2006. "Optimal Inflation Targeting Under Alternative Fiscal Regimes," Working Papers Central Bank of Chile 407, Central Bank of Chile.
  15. Christopher Allsopp & David Vines, 2005. "The Macroeconomic Role of Fiscal Policy," Oxford Review of Economic Policy, Oxford University Press, vol. 21(4), pages 485-508, Winter.
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  18. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," CEPR Discussion Papers 1750, C.E.P.R. Discussion Papers.
  19. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April.
  20. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
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