Debt Stabilization Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence

54 Pages Posted: 28 Nov 2007

See all articles by Sven Jari Stehn

Sven Jari Stehn

Brasenose College; International Monetary Fund (IMF)

David Vines

University of Oxford - Balliol College - Department of Economics; Australian National University (ANU); Centre for Economic Policy Research (CEPR)

Date Written: August 2007

Abstract

We analyse optimal monetary and fiscal policy in a New-Keynesian model with public debt and inflation persistence. Leith and Wren-Lewis (2007) have shown that optimal discretionary policy is subject to a 'debt stabilization bias' which requires debt to be returned to its pre-shock level. This finding has two important implications for optimal discretionary policy. Firstly, as Leith and Wren-Lewis have shown, optimal monetary policy in an economy with high steady-state debt cuts the interest rate in response to a cost-push shock - and therefore violates the Taylor principle. We show that this striking result is not true with high degrees of inflation persistence. Secondly, we show that optimal fiscal policy is more active under discretion than commitment at all degrees of inflation persistence and all levels of debt.

Keywords: Working Paper, Public debt, Monetary policy, Fiscal policy, Inflation, Economic stabilization

Suggested Citation

Stehn, Sven Jari and Vines, David, Debt Stabilization Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence (August 2007). IMF Working Papers, Vol. , pp. 1-52, 2007. Available at SSRN: https://ssrn.com/abstract=1033206

Sven Jari Stehn (Contact Author)

Brasenose College ( email )

Oxford OX1 4AJ
United Kingdom

International Monetary Fund (IMF)

700 19th Street, N.W.
Washington, DC 20431
United States

David Vines

University of Oxford - Balliol College - Department of Economics ( email )

Manor Road
Oxford, OX1 3BJ, Oxfordshire OX13UQ
United Kingdom
+44 1865 271 067 (Phone)
+44 1865 271 094 (Fax)

Australian National University (ANU)

Canberra, Australian Capital Territory
Australia

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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