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Inflation's Role in Optimal Monetary-Fiscal Policy

  • Eric M. Leeper
  • Xuan Zhou

We study how the maturity structure of nominal government debt affects optimal monetary and fiscal policy decisions and equilibrium outcomes in the presence of distortionary taxes and sticky prices. Key findings are: (1) there is always a role for current and future inflation innovations to revalue government debt, reducing reliance on distorting taxes; (2) the role of inflation in optimal fiscal financing increases with the average maturity of government debt; (3) as average maturity rises, it is optimal to tradeoff inflation for output stabilization; (4) inflation is relatively more important as a fiscal shock absorber in high-debt than in low-debt economies; (5) in some calibrations that are relevant to U.S. data, welfare under the fully optimal monetary and fiscal policies can be made equivalent to the welfare under the conventional optimal monetary policy with passively adjusting lump-sum taxes by extending the average maturity of bond.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19686.

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Date of creation: Nov 2013
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Handle: RePEc:nbr:nberwo:19686
Note: EFG
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  1. Pierpaolo Benigno & Michael Woodford, 2004. "Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach," NBER Chapters, in: NBER Macroeconomics Annual 2003, Volume 18, pages 271-364 National Bureau of Economic Research, Inc.
  2. Tatiana Kirsanova & Simon Wren-Lewis, 2006. " Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities," CDMA Conference Paper Series 0609, Centre for Dynamic Macroeconomic Analysis.
  3. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December.
  4. Stefano Eusepi & Bruce Preston, 2013. "Fiscal foundations of inflation: imperfect knowledge," Staff Reports 649, Federal Reserve Bank of New York.
  5. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2009. "Monetary and Fiscal Policy Interaction: The Current Consensus Assignment in the Light of Recent Developments," Economic Journal, Royal Economic Society, vol. 119(541), pages F482-F496, November.
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