Debt stabilisation bias and the Taylor principle: Optimal policy in a New Keynesian model with government debt and inflation persistence

Vol: 
22/2007
Author name: 
Stehn SJ
Vines D
Year: 
2007
Month: 
October
Abstract: 

Leith and Wren-Lewis (2007) have shown that government debt is returned to its pre-shock level in a New Keynesian model under optimal discretionary policy. This has two important implications for monetary and fiscal policy. First, in a high-debt economy, it may be optimal for discretionary monetary policy to cut the interest rate in response to a cost-push shock - thereby violating the Taylor principle - although this will not be true if inflation is significantly persistent. Second, the optimal fiscal response to such a shock is more active under discretion than commitment, whatever the degree of inflation persistence.

Publication file: 

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