Government debt and optimal monetary and fiscal policy


Adam, Klaus


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DOI: https://doi.org/10.1016/j.euroecorev.2010.11.003
URL: https://ub-madoc.bib.uni-mannheim.de/31881
Additional URL: https://www.sciencedirect.com/science/article/pii/...
URN: urn:nbn:de:bsz:180-madoc-318819
Document Type: Article
Year of publication: 2011
The title of a journal, publication series: European Economic Review : EER
Volume: 55
Issue number: 1
Page range: 57-74
Place of publication: Amsterdam
Publishing house: Elsevier
ISSN: 0014-2921
Publication language: English
Institution: School of Law and Economics > VWL, Internat. Wirtschaftsbeziehungen (Adam)
Subject: 330 Economics
Classification: JEL: E63 , E61,
Keywords (English): Ramsey optimal policy; Second-order approximation; Non-contingent debt; Sticky prices
Abstract: How do different levels of government debt affect the optimal conduct of monetary and fiscal policies? And what do these optimal policies imply for the evolution of government debt over time? To provide an answer, this paper studies a standard monetary policy model with nominal rigidities and monopolistic competition and adds to it a fiscal authority that issues nominal non-state contingent debt, levies distortionary labor income taxes and determines the level of public goods provision. Higher government debt levels make it optimal to reduce public spending, so as to dampen the adverse incentive effects of distortionary taxes, but also strongly influence the optimal stabilization response following technology shocks. In particular, higher debt levels give rise to larger risks to the fiscal budget and to tax rates. This makes it optimal to reduce government debt over time. The optimal speed of debt reduction is missed when using first-order approximations to optimal policies, but is shown to be quantitatively significant in a second-order approximation, especially when technology movements are largely unpredictable in nature.

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