Working Paper: CEPR ID: DP3753
Authors: Roel Beetsma; A. Lans Bovenberg
Abstract: We explore the dynamics of public debt in the presence of political shocks, in the form of shocks to preferences for public spending. Under commitment, optimal stabilization is obtained by combining an inflation target that is contingent on the political shock with a debt target that forces the government to fully absorb the political shock in the period in which it occurs. With only a shock-contingent inflation target, the political shock is spread out over time through debt policy. In the absence of any targets, a conservative central bank can enhance stabilization. If we extend the basic two-period model to an infinite horizon, this result is preserved. Moreover, under rather general circumstances the government tends to decumulate debt over time, so that in the long run all targets (for inflation, output and public spending) are attained. A failure to commit monetary policy introduces an additional distortion into the model, which leads the government to decumulate debt at a faster rate.
Keywords: Central Bank Conservatism; Commitment; Debt Targets; Discretion; Inflation Targets; Political Shocks; Public Debt
JEL Codes: E52; E58; E61; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| political shocks (F69) | public debt (H63) |
| political spending preferences (D72) | public debt (H63) |
| optimal stabilization policies (E63) | public debt (H63) |
| inflation target reacting to political shocks (E63) | public debt (H63) |
| central bank conservatism (E58) | public debt (H63) |
| lack of commitment to monetary policy (E60) | debt accumulation (H63) |