DP6696 | Debt Stabilisation Bias and the Taylor Principle: Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence

Publication Date

07/02/2008

JEL Code(s)

Keyword(s)

Programme Area(s)

Network(s)

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.