Working Paper: CEPR ID: DP10580
Authors: Paul Luk; David Vines
Abstract: This paper uses a New Keynesian framework to study the coordination of fiscal and monetary policies, in response to an inflation shock when the policymaker acts with commitment. We first show that, in the simplest New Keynesian model, fiscal policy plays no part in the optimal policy response, because of the comparative advantage which monetary policy has in the control of inflation. We then add endogenous public debt and show that the above result is no longer true. When the initial stock of debt is low, it is optimal for government spending to remain largely inactive, but when the initial stock of debt is high, government spending should play a significant stabilisation role in the first period. This finding is robust to adding endogenous capital accumulation and inflation persistence in the Phillips curve.
Keywords: Fiscal Policy; Government Debt; Monetary Policy; New Keynesian Model
JEL Codes: E4; E5; E6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| initial public debt levels (H63) | effectiveness of fiscal policy in stabilizing inflation (E63) |
| initial public debt levels (H63) | comparative advantage of monetary policy in controlling inflation (E63) |
| high initial public debt (H63) | government spending must play an active role in stabilization during inflation shock (E63) |
| relying solely on monetary policy (E52) | excessive accumulation of public debt (H63) |
| initial public debt is low (H63) | comparative advantage of monetary policy remains dominant (E63) |
| endogenous capital accumulation and inflation persistence (E22) | optimal policy responses (E61) |