DP6595 Nominal Debt as a Burden on Monetary Policy

Author(s): Javier Díaz-Giménez , Giorgia Giovannetti , Ramon Marimon , Pedro Teles

Publication Date: December 2007

Keyword(s): indexed debt , Markov-perfect equilibrium , nominal debt , optimal monetary policy , time consistency

JEL(s): E40 , E50 , E58 , E60

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6595.asp.asp

We characterize the optimal sequential choice of monetary policy in economies with either nominal or indexed debt. In a model where nominal debt is the only source of time inconsistency, the Markov-perfect equilibrium policy implies the progressive depletion of the outstanding stock of debt, until the time inconsistency disappears. There is a resulting welfare loss if debt is nominal rather than indexed. We also analyze the case where monetary policy is time inconsistent even when debt is indexed. In this case, with nominal debt, the sequential optimal policy converges to a time-consistent steady state with positive -- or negative -- debt, depending on the value of the intertemporal elasticity of substitution. Welfare can be higher if debt is nominal rather than indexed and the level of debt is not too high.