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

Author(s): Sven Jari Stehn , David Vines

Publication Date: February 2008

Keyword(s): Government Debt , Monetary Policy , Stabilisation Bias , Fiscal Policy

JEL(s): E52 , E60 , E61 , E63

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6696.asp.asp

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.