Working Paper: CEPR ID: DP6696
Authors: Sven Jari Stehn; David Vines
Abstract: Leith and Wren-Lewis (2007) have shown that government debt is returned to its pre-shock level in a New Keynesian model under optimal discretionary policy. This has two important implications for monetary and fiscal policy. First, in a high-debt economy, it may be optimal for discretionary monetary policy to cut the interest rate in response to a cost-push shock - thereby violating the Taylor principle - although this will not be true if inflation is significantly persistent. Second, the optimal fiscal response to such a shock is more active under discretion than commitment, whatever the degree of inflation persistence.
Keywords: Fiscal Policy; Government Debt; Monetary Policy; Stabilisation Bias
JEL Codes: E52; E60; E61; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high government debt (H63) | interest rates (E43) |
| inflation persistence (E31) | violation of the Taylor principle (E31) |
| discretionary policy (E60) | optimal fiscal response to cost-push shocks (E63) |
| inability to commit (D91) | stabilisation bias (E71) |
| stabilisation bias (E71) | monetary and fiscal policy dynamics (E63) |
| inflation persistence (E31) | deviations from the Taylor principle (E19) |
| fiscal policy actions (E62) | economic stability outcomes (E63) |
| past policy decisions (D78) | current economic conditions (E66) |