Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities
34 Pages Posted: 8 Nov 2006 Last revised: 6 Jul 2014
Date Written: August 6, 2010
We examine the impact of different degrees of fiscal feedback on debt in an economy with nominal rigidities where monetary policy is determined optimally, rather than following a simple rule. We look at the extent to which different degrees of fiscal feedback enhances or detracts from the ability of the monetary authorities to stabilise output and inflation. Using an objective function derived from utility, we find the optimal level of fiscal feedback to be small. There is a clear discontinuity in the behaviour of monetary policy and welfare either side of this optimal level. As the extent of fiscal feedback increases, optimal monetary policy becomes less active because fiscal feedback tends to deflate inflationary shocks. However this fiscal stabilisation is less efficient than monetary stabilisation, and so welfare declines. In contrast, if fiscal feedback falls below some critical value optimal monetary policy becomes strongly passive, and this passive monetary policy leads to a sharp deterioration in welfare.
Keywords: Fiscal Policy, Feedback Rules, Debt, Macroeconomic Stabilisation
JEL Classification: E52, E61, E63, F41
Suggested Citation: Suggested Citation