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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. 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.
  2. Obstfeld, Maurice, 1997. "Dynamic Seigniorage Theory," Macroeconomic Dynamics, Cambridge University Press, vol. 1(03), pages 588-614, September.
  3. Martin Ellison & Neil Rankin, 2005. " Optimal Monetary Policy When Lump-Sum Taxes Are Unavailable: A Reconsideration of the Outcomes under Commitment and Discretion," CDMA Conference Paper Series 0501, Centre for Dynamic Macroeconomic Analysis.
  4. 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.
  5. Peter N. Ireland, 2002. "Technology Shocks in the New Keynesian Model," Boston College Working Papers in Economics 536, Boston College Department of Economics.
  6. 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.).
  7. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  8. 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.
  9. 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.
  10. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October.
  11. 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.
  12. Frank Smets & Raf Wouters, 2004. "Comparing shocks and frictions in US and euro area business cycles: a Bayesian DSGE approach," Working Paper Research 61, National Bank of Belgium.
  13. 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.
  14. Campbell leith & Simon Wren-Lewis, . "Compatibility Between Monetary and Fiscal Policy Under EMU," Working Papers 2001_15, Business School - Economics, University of Glasgow.
  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. 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.
  17. 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.
  18. 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.
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