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Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities

Authors


  • Corresponding author: Tatiana Kirsanova, School of Business and Economics, University of Exeter, Streatham Court, Rennes Drive, Exeter EX4 4PU, UK. Email: t.kirsanova@exeter.ac.uk

  • We thank Richard Dennis, John Driffill, Martin Ellison, Campbell Leith, Paul Levine, Patrick Minford, Joe Perlman, Alan Sutherland and participants at a conference organised by the Federal Reserve Bank of Atlanta (particularly Eric Leeper, James Nason, Stephanie Schmitt-Grohe, Chris Sims and Martin Uribe), as well as referees and the editor, for helpful comments and discussions. Any errors are ours.

Abstract

We examine the impact of different degrees of fiscal feedback on debt when monetary policy is determined optimally, rather than following a simple rule. We find the welfare maximising level of fiscal feedback to be small. We show for the first time a clear discontinuity in the behaviour of monetary policy and welfare either side of this optimal level. As fiscal feedback increases, optimal monetary policy becomes less active because fiscal feedback tends to deflate inflationary shocks. If fiscal feedback falls below some critical value, monetary policy becomes strongly passive and this leads to a sharp deterioration in welfare.

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