Flexible inflation targeting with active fiscal policy

Richard Harrison

No 928, Bank of England working papers from Bank of England

Abstract: This paper studies optimal time‑consistent monetary policy in a simple New Keynesian model with long‑term nominal government debt. Fiscal policy is ‘active’, so that stabilisation of the government debt stock is a binding constraint on monetary policy. Away from the lower bound on the monetary policy rate, optimal monetary policy cannot fully offset the effects of shocks to the natural rate of interest, reducing welfare. At the lower bound, recessionary shocks increase the real value of government debt, generating the anticipation of higher future inflation to stabilise real debt. Higher inflation expectations reduce real interest rates, mitigating the effects of recessionary shocks. If debt duration is long enough, improved performance at the lower bound may outweigh higher welfare losses in normal times, compared with the case in which fiscal policy is ‘passive’.

Keywords: Optimal monetary policy; fiscal policy; effective lower bound; government debt (search for similar items in EconPapers)
JEL-codes: E52 E58 E62 (search for similar items in EconPapers)
Pages: 51 pages
Date: 2021-07-02
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:0928

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