Abstract
Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady‐state debt to follow a random walk. In this paper we consider the nature of the time inconsistency involved in such a policy and its implication for discretionary policymaking. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady‐state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government's objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi‐commitment policy, which allows for different probabilities of reneging on past promises.
Highlights
Most recent work deriving optimal monetary policy utilising New Neo-Classical Synthesis (NNCS) models abstract from the impact of monetary policy on the government’s finances, by assuming that any change in the government’s budget can be financed through lump sum taxes
There has been a wealth of recent work deriving optimal monetary policy utilising New Neo-Classical Synthesis (NNCS) models
Cet. par. the value of the multiplier will not be as large when the policy maker exploits fixed expectations in the initial period to raise additional tax revenue and deflate the debt. This implies that, in the case of a shock with a higher debt stock, output, consumption and government spending will not fall by as much, and taxes will not need to rise by as much to support the new steady-state debt stock, which is lower than it would be under a policy which did not exploit the fact that expectations are given in the initial period
Summary
There has been a wealth of recent work deriving optimal monetary policy utilising New Neo-Classical Synthesis (NNCS) models. There has been previous work examining time-consistency problems in the presence of debt, but this has been in models based on flexible prices - to the extent that the surprise inflation is not merely used to offset the fiscal effects of shocks a potential time-inconsistency problem exists This timeinconsistency problem need not imply a positive inflation bias in the presence of positive debt stocks, but can be consistent with the Friedman rule (Obstfeld, 1991,1997), or, for alternative preferences, a positive steady-state debt level where the time-inconsistency problem has been eliminated (Ellison and Rankin (2006)). This informs the simulation results, which reveal that operating under discretion overturns the usual random walk result and can potentially generate significant welfare costs
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