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

36 Pages Posted: 9 Jun 2008

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: February 2008

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 Classification: E52, E60, E61, E63

Suggested Citation

Stehn, Sven Jari and Vines, David, Debt Stabilisation Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence (February 2008). CEPR Discussion Paper No. DP6696. Available at SSRN: https://ssrn.com/abstract=1141018

Sven Jari Stehn

Brasenose College ( email )

Oxford OX1 4AJ
United Kingdom

International Monetary Fund (IMF)

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

David Vines (Contact Author)

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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