Fiscal sustainability in a new Keynesian model

Leith, C. and Wren-Lewis, S. (2013) Fiscal sustainability in a new Keynesian model. Journal of Money, Credit and Banking, 45(8), pp. 1477-1516. (doi: 10.1111/jmcb.12060)

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Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady-state debt to follow a random walk. In this paper we consider the nature of the time inconsistency involved in such a policy and its implication for discretionary policymaking. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government's objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi-commitment policy, which allows for different probabilities of reneging on past promises.

Item Type:Articles
Additional Information:See also: Additional appendix: <a href=""></a>
Glasgow Author(s) Enlighten ID:Leith, Professor Campbell
Authors: Leith, C., and Wren-Lewis, S.
College/School:College of Social Sciences > Adam Smith Business School > Economics
Journal Name:Journal of Money, Credit and Banking
ISSN (Online):1538-4616
Published Online:22 November 2013
Copyright Holders:Copyright © 2013 The Authors
First Published:First published in Journal of Money, Credit and Banking 45(8):1477-1516
Publisher Policy:Reproduced under a Creative Commons License

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Project CodeAward NoProject NamePrincipal InvestigatorFunder's NameFunder RefLead Dept
480171New Directions in Monetary and Fiscal Policy Analysis at the Macroeconomic LevelCampbell LeithEconomic & Social Research Council (ESRC)ES/G006873/1BUS - ECONOMICS