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Optimal Time-Consistent Monetary, Fiscal and Debt Maturity Policy

Eric Leeper (), Campbell Leith () and Ding Liu ()

Working Papers from Business School - Economics, University of Glasgow

Abstract: We develop a New Keynesian model with government bonds of mixed matu- rity and solve for optimal time-consistent policy using global solution techniques. This reveals several non-linearities absent from LQ analyses with one-period debt. Firstly, the steady-state balances an inflation and debt stabilization bias to gener- ate a small negative debt value with a slight undershooting of the inflation target. This falls far short of first-best (`war chest') asset levels. Secondly, starting from debt levels consistent with currently observed debt to GDP ratios the optimal pol- icy will gradually reduce that debt, but the policy mix changes radically along the transition path. At high debt levels there is a reliance on a relaxation of monetary policy to reduce debt through an expanded tax base and reduced debt service costs, while tax rates are used to moderate the increases in inflation. However, as debt levels fall, the use of monetary policy in this way diminishes and the authority turns to fiscal policy to continue debt reduction. This endogenous switch in the policy mix occurs at higher debt levels, the longer the average debt maturity. Allowing the policymaker to optimally vary debt maturity in response to shocks and across varying levels of debt, we find that variations in maturity are largely used to sup- port changes in the underlying time-consistent policy mix rather than the speed of fiscal correction. Finally, introducing a mild degree of policy maker myopia can re- produce steady-state debt to GDP ratios and inflation rates not dissimilar to those observed empirically, without changing any of the qualitative results presented in the paper.

Keywords: New Keynesian Model; Government Debt; Monetary Policy; Fiscal Policy; Credibility; Time Consistency; Maturity Structure. (search for similar items in EconPapers)
JEL-codes: E62 E63 (search for similar items in EconPapers)
Date: 2016-01
New Economics Papers: this item is included in nep-mac and nep-pbe
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Related works:
Journal Article: Optimal Time-Consistent Monetary, Fiscal and Debt Maturity Policy (2021) Downloads
Working Paper: Optimal Time-Consistent Monetary, Fiscal and Debt Maturity Policy (2019) Downloads
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