Optimal Monetary Policy and Fiscal Interactions in a Non-Ricardian Economy

65 Pages Posted: 8 Dec 2017

Date Written: December 5, 2017

Abstract

This paper studies optimal discretionary monetary policy and its interaction with fiscal policy in a New Keynesian model with finitely-lived consumers and government debt. Optimal discretionary monetary policy involves debt stabilization to reduce consumption dispersion across cohorts of consumers. The welfare relevance of debt stabilization is proportional to the debt-to-output ratio and inversely related to the households probability of survival that affects the household’s propensity to consume out financial wealth. Debt stabilization bias implies that discretionary optimal policy is suboptimal compared with the inflation targeting rule that fully stabilizes the output gap and the inflation rate while leaving debt to freely fluctuate in response to demand shocks.

Keywords: optimal monetary policy, fiscal and monetary policy interaction

JEL Classification: E53, E63

Suggested Citation

Rigon, Massimiliano and Zanetti, Francesco, Optimal Monetary Policy and Fiscal Interactions in a Non-Ricardian Economy (December 5, 2017). Bank of Italy Temi di Discussione (Working Paper) No. 1155. Available at SSRN: https://ssrn.com/abstract=3084014 or http://dx.doi.org/10.2139/ssrn.3084014

Massimiliano Rigon (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Francesco Zanetti

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

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