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Fiscal Sustainability in a New Keynesian Model

  • Campbell Leith
  • Simon Wren-Lewis

Most recent work deriving optimal monetary policy utilising New Neo-Classical Synthesis (NNCS) models abstract from the impact of monetary policy on the government’s finances, by assuming the existence of lump sum taxes. In this paper, we assume that the government does not have access to such taxes to satisfy its intertemporal budget constraint in the face of shocks. 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. We also find that the time-inconsistency in the optimal precommitment policy is such that governments are tempted, given inflationary expectations, to utilise their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We show that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level. This implies that under a 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. Analytically and in a series of numerical simulations we show which instrument is used to stabilise the debt depends crucially on the degree of nominal inertia and the size of the debt-stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy.

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2006_11.

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Date of creation: Oct 2006
Date of revision: Nov 2008
Handle: RePEc:gla:glaewp:2006_11
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  1. 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.
  2. Obstfeld, Maurice, 1997. "Dynamic Seigniorage Theory," Macroeconomic Dynamics, Cambridge University Press, vol. 1(03), pages 588-614, September.
  3. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  4. Benigno, Pierpaolo & Woodford, Michael, 2004. "Optimal monetary and fiscal policy: a linear-quadratic approach," Working Paper Series 0345, European Central Bank.
  5. Obstfeld, Maurice, 1997. "Dynamic Seigniorage Theory: An Exploration," Department of Economics, Working Paper Series qt712610vq, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  6. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  7. 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.
  8. Leith, Campbell & Simon Wren-Lewis, 2002. "Compatibility Between Monetary and Fiscal Policy Under EMU," Royal Economic Society Annual Conference 2002 124, Royal Economic Society.
  9. Beetsma, Roel M. W. J. & Jensen, Henrik, 2004. "Mark-up fluctuations and fiscal policy stabilization in a monetary union," Journal of Macroeconomics, Elsevier, vol. 26(2), pages 357-376, June.
  10. Söderlind, Paul, 1998. "Solution and Estimation of RE Macromodels with Optimal Policy," SSE/EFI Working Paper Series in Economics and Finance 256, Stockholm School of Economics.
  11. Smets, Frank & Wouters, Rafael, 2004. "Comparing Shocks and Frictions in US and Euro Area Business Cycles: A Bayesian DSGE Approach," CEPR Discussion Papers 4750, C.E.P.R. Discussion Papers.
  12. Peter N. Ireland, 2002. "Technology Shocks in the New Keynesian Model," Boston College Working Papers in Economics 536, Boston College Department of Economics.
  13. 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.
  14. 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.
  15. Lombardo, Giovanni & Sutherland, Alan, 2003. "Monetary and fiscal interactions in open economies," Working Paper Series 0289, European Central Bank.
  16. Leith, Campbell & Malley, Jim, 2005. "Estimated general equilibrium models for the evaluation of monetary policy in the US and Europe," European Economic Review, Elsevier, vol. 49(8), pages 2137-2159, November.
  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. 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.
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