Working Paper: CEPR ID: DP8064
Authors: Klaus Adam
Abstract: How do different levels of government debt affect the optimal conduct of monetary and fiscal policies? And what do these optimal policies imply for the evolution of government debt over time? To provide an answer, this paper studies a standard monetary policy model with nominal rigidities and monopolistic competition and adds to it a fiscal authority that issues nominal non-state contingent debt, levies distortionary labor income taxes and determines the level of public goods provision. Higher government debt levels make it optimal to reduce public spending, so as to dampen the adverse incentive effects of distortionary taxes, but also strongly influence the optimal stabilization response following technology shocks. In particular, higher debt levels give rise to larger risks to the fiscal budget and to tax rates. This makes it optimal to reduce government debt over time. The optimal speed of debt reduction is missed when using first order approximations to optimal policies, but is shown to be quantitatively significant in a second order approximation, especially when technology movements are largely unpredictable in nature.
Keywords: Noncontingent Debt; Ramsey Optimal Policy; Second Order Approximation; Sticky Prices
JEL Codes: E61; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher government debt levels (H63) | reduction in public spending (H69) |
| higher government debt levels (H63) | increase in fiscal budget risks (E62) |
| increase in fiscal budget risks (E62) | necessitates gradual reduction in government debt over time (H60) |
| higher government debt levels (H63) | increase in tax rates (H29) |
| higher government debt levels (H63) | influence optimal stabilization response to technology shocks (E63) |
| reduction in public spending (H69) | dampen adverse incentive effects of distortionary labor income taxes (H31) |
| higher government debt levels (H63) | optimal speed of debt reduction is influenced by level of accumulated debt (H63) |
| optimal speed of debt reduction is influenced by level of accumulated debt (H63) | optimal speed of debt reduction is influenced by nature of technology shocks (O49) |