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Fiscal Sustainability in a New Keynesian Model

  • Campbell Leith

    (University of Glasgow)

  • Simon Wren-lewis

    (University of Exeter)

There has been a wealth of recent work deriving optimal monetary policy utilising New Neo-Classical Synthesis (NNCS) models based on nominal inertia. Such models typically abstract from the impact of monetary policy on the government’s finances, by assuming that consumers are infinitely-lived and taxes are lump-sum such that Ricardian Equivalence holds. In this paper, in the context of a sticky-price NNCS model, we assume that the government must adjust spending and/or distortionary taxation to satisfy its intertemporal budget constraint. 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. In the case of negative fiscal shocks this implies permanently higher taxation and lower output and government spending to support the new steady-state debt stock, but the optimal combination of these variables will ensure a zero rate of inflation under commitment. We also find that the time-inconsistency in the optimal precommitment policy is such that governments are tempted, given inflationary expectations, to raise taxation to reduce the ultimate debt burden they need to service. Since taxation is a distortionary labour income tax, this aggressive raising of taxation raises firms’ marginal costs and fuels inflation. We show that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original, first-best, debt level. This implies that under 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. In a series of numerical simulations we 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 ESRC World Economy and Finance Research Programme, Birkbeck, University of London in its series WEF Working Papers with number 0006.

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Date of creation: Mar 2006
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Handle: RePEc:wef:wpaper:0006
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  1. Smets, Frank & Wouters, Raf, 2004. "Comparing shocks and frictions in US and euro area business cycles: a Bayesian DSGE approach," Working Paper Series 0391, European Central Bank.
  2. 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.
  3. 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.
  4. 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.
  5. Obstfeld, Maurice, 1997. "Dynamic Seigniorage Theory," Macroeconomic Dynamics, Cambridge University Press, vol. 1(03), pages 588-614, September.
  6. 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.
  7. Leith, Campbell & Simon Wren-Lewis, 2002. "Compatibility Between Monetary and Fiscal Policy Under EMU," Royal Economic Society Annual Conference 2002 124, Royal Economic Society.
  8. 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.
  9. Benigno, Pierpaolo & Woodford, Michael, 2004. "Optimal monetary and fiscal policy: a linear-quadratic approach," Working Paper Series 0345, European Central Bank.
  10. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April.
  11. Peter N. Ireland, 2004. "Technology Shocks in the New Keynesian Model," NBER Working Papers 10309, National Bureau of Economic Research, Inc.
  12. 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.
  13. 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.
  14. Lombardo, Giovanni & Sutherland, Alan, 2003. "Monetary and fiscal interactions in open economies," Working Paper Series 0289, European Central Bank.
  15. 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.
  16. 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.
  17. 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.
  18. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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