DP3753 Political Shocks, Public Debt and the Design of Monetary and Fiscal Institutions

Author(s): Roel Beetsma , A Lans Bovenberg

Publication Date: February 2003

Keyword(s): political shocks , public debt , commmitment , discretion , inflation targets , debt targets , central bank conservatism

JEL(s): E52 , E58 , E61 , E62

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3753.asp

We explore the dynamics of public debt in the presence of political shocks, in the form of shocks to preferences for public spending. Under commitment, optimal stabilization is obtained by combining an inflation target that is contingent on the political shock with a debt target that forces the government to fully absorb the political shock in the period in which it occurs. With only a shock-contingent inflation target, the political shock is spread out over time through debt policy. In the absence of any targets, a conservative central bank can enhance stabilization. If we extend the basic two-period model to an infinite horizon, this result is preserved. Moreover, under rather general circumstances the government tends to decumulate debt over time, so that in the long run all targets (for inflation, output and public spending) are attained. A failure to commit monetary policy introduces an additional distortion into the model, which leads the government to decumulate debt at a faster rate.