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(Optimal) Monetary Policy with and without Debt

Boris Chafwehé (), Rigas Oikonomou, Romanos Priftis () and Lukas Vogel ()

Staff Working Papers from Bank of Canada

Abstract: We propose a framework of optimal monetary policy where debt sustainability may, or may not, be a relevant constraint for the central bank. We show analytically that in each environment the optimal interest rate path consists of a Taylor rule augmented with forward guidance terms. These terms arise either i) from “twisting interest rates” when the central bank ensures debt sustainability, or ii) under no debt concerns, from committing to keep interest rates low at the exit of the liquidity trap. The optimal policy is isomorphic to Leeper’s (1991) “passive monetary/active fiscal policy” regime in the first instance, or “active monetary/passive fiscal policy” regime in the second. We insert our framework into a standard medium scale DSGE model calibrated to the US. Optimal passive monetary policy with debt concerns is ineffective in stabilizing inflation, whereas under no debt concerns, monetary policy is very effective in stabilizing the macroeconomy.

Keywords: Economic models; Fiscal policy; Monetary policy; Monetary policy framework (search for similar items in EconPapers)
JEL-codes: C11 E31 E52 E58 E62 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2021-01
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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