Publisher:
Birkbeck, University of London, Birkbeck Centre for Applied Macroeconomics (BCAM), London
Abstract:
This paper studies optimal discretionary monetary policy and its interaction with fiscal policy in a New Keynesian model with finitely-lived consumers and gov- ernment debt. Optimal discretionary monetary policy involves debt stabilization to reduce consumption dispersion across cohorts of consumers. The welfare relevance of debt stabilization is proportional to the debt-to-output ratio and inversely related to the household's probability of survival that a¤ects the household's propensity to consume out financial wealth. Debt stabilization bias implies that discretionary optimal policy is suboptimal compared with the inflation targeting rule that fully stabilizes the output gap and the inflation rate while leaving debt to freely fluctuate in response to demand shocks.