Debt Stabilization Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence
IMF Working Papers, August 1, 2007
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- Debt Stabilization Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence
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Bibliographic details
- Authors: David A Vines, Sven Jari Stehn
- Published: August 1, 2007
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451867701.001
Summary of analysis
- The paper analyses optimal monetary and fiscal policy in a New-Keynesian model with public debt and inflation persistence.
- It builds on Leith and Wren-Lewis (2007), who show that optimal discretionary policy is subject to a "debt stabilization bias" which requires debt to be returned to its pre-shock level.
Core findings
- Debt stabilization bias:
- Optimal discretionary policy is subject to a "debt stabilization bias" that requires debt to be returned to its pre-shock level.
- Interaction of debt and the Taylor principle:
- Leith and Wren-Lewis found that optimal monetary policy in an economy with high steady-state debt cuts the interest rate in response to a cost-push shock and therefore violates the Taylor principle.
- This paper shows that the result that optimal monetary policy cuts the interest rate in response to a cost-push shock is not true when there are high degrees of inflation persistence.
- Fiscal policy under discretion versus commitment:
- Optimal fiscal policy is more active under discretion than under commitment at all degrees of inflation persistence and all levels of debt.
Policy implications and recommendations
- Monetary policy design:
- The conventional implication that high steady-state debt leads optimal discretionary monetary policy to violate the Taylor principle depends critically on the degree of inflation persistence; high inflation persistence can alter that implication.
- Fiscal policy stance:
- Policymakers should expect fiscal policy to be more active under discretionary regimes than under commitment, regardless of inflation persistence or debt levels.
Subjects and keywords
- Subject: Consumption, Debt bias, Fiscal policy, Inflation, Inflation persistence, National accounts, Prices, Tax policy
- Keywords: Consumption, cost-push shock, Debt bias, debt economy, feedback coefficient, Fiscal Policy, Government Debt, Inflation, inflation expectation, Inflation persistence, Lagrange multiplier, monetary policy, stabilisation bias, Stabilization Bias, WP
IMF Working Papers. "Debt Stabilization Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence", By David A Vines, Sven Jari Stehn, August 1, 2007.