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Government Debt and Optimal Monetary and Fiscal Policy

  • Adam, Klaus

How do different levels of government debt affect the optimal conduct of monetary and fiscal policies? And what do these optimal policies imply for the evolution of government debt over time? To provide an answer, this paper studies a standard monetary policy model with nominal rigidities and monopolistic competition and adds to it a fiscal authority that issues nominal non-state contingent debt, levies distortionary labor income taxes and determines the level of public goods provision. Higher government debt levels make it optimal to reduce public spending, so as to dampen the adverse incentive effects of distortionary taxes, but also strongly influence the optimal stabilization response following technology shocks. In particular, higher debt levels give rise to larger risks to the fiscal budget and to tax rates. This makes it optimal to reduce government debt over time. The optimal speed of debt reduction is missed when using first order approximations to optimal policies, but is shown to be quantitatively significant in a second order approximation, especially when technology movements are largely unpredictable in nature.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8064.

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Date of creation: Oct 2010
Handle: RePEc:cpr:ceprdp:8064
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  1. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Staff Report 147, Federal Reserve Bank of Minneapolis.
  2. Martin Uribe & Stephanie Schmitt-Grohe, 2001. "Optimal fiscal and monetary policy under sticky prices," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  3. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
  4. Javier Diaz-Gimenez & Giorgia Giovannetti & Ramon Marimon & Pedro Teles, 2007. "Nominal Debt as a Burden on Monetary Policy," Economics Working Papers ECO2007/53, European University Institute.
  5. Sbordone, Argia, 1998. "Prices and Unit Labor Costs: A New Test of Price Stickiness," Seminar Papers 653, Stockholm University, Institute for International Economic Studies.
  6. Adam, Klaus & Billi, Roberto M, 2010. "Distortionary fiscal policy and monetary policy goals," CEPR Discussion Papers 7741, C.E.P.R. Discussion Papers.
  7. Leith, Campbell & Moldovan, Ioana & Rossi, Raffaele, 2015. "Monetary and fiscal policy under deep habits," Journal of Economic Dynamics and Control, Elsevier, vol. 52(C), pages 55-74.
  8. Gomme, Paul & Klein, Paul, 2011. "Second-order approximation of dynamic models without the use of tensors," Journal of Economic Dynamics and Control, Elsevier, vol. 35(4), pages 604-615, April.
  9. Adam, Klaus & Billi, Roberto M., 2004. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," CFS Working Paper Series 2004/13, Center for Financial Studies (CFS).
  10. Adam, Klaus & Billi, Roberto M, 2006. "Monetary Conservatism and Fiscal Policy," CEPR Discussion Papers 5740, C.E.P.R. Discussion Papers.
  11. 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.
  12. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
  13. Woodford, M., 1997. "Doing Without Money: Controlling Inflation in a Post-Monetary World," Papers 632, Stockholm - International Economic Studies.
  14. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  15. 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.
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