Flexible inflation targeting with active fiscal policy

Abstract

This paper studies optimal time‑consistent monetary policy in a simple New Keynesian model with long‑term nominal government debt. Fiscal policy is ‘active’, so that stabilisation of the government debt stock is a binding constraint on monetary policy. Away from the lower bound on the monetary policy rate, optimal monetary policy cannot fully offset the effects of shocks to the natural rate of interest, reducing welfare. At the lower bound, recessionary shocks increase the real value of government debt, generating the anticipation of higher future inflation to stabilise real debt. Higher inflation expectations reduce real interest rates, mitigating the effects of recessionary shocks. If debt duration is long enough, improved performance at the lower bound may outweigh higher welfare losses in normal times, compared with the case in which fiscal policy is ‘passive’.