Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities

Tatiana Kirsanova and Simon Wren-Lewis
Working Paper 2007-26
December 2007

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We examine the impact of different degrees of fiscal feedback on debt in an economy with nominal rigidities where monetary policy is optimal. We look at the extent to which different degrees of fiscal feedback enhance or detract from the ability of the monetary authorities to stabilize output and inflation. Using an objective function derived from utility, we find the optimal level of fiscal feedback to be small. A clear discontinuity exists in the behavior of monetary policy and welfare on either side of this optimal level. As the extent of fiscal feedback increases, optimal monetary policy becomes less active because fiscal feedback tends to deflate inflationary shocks. However, this fiscal stabilization is less efficient than monetary policy, so welfare declines. In contrast, if fiscal feedback falls below some critical value, optimal monetary policy becomes strongly passive, and this passive monetary policy leads to a sharp deterioration in welfare.

JEL classification: E52, E61, E63, F41

Key words: fiscal policy, feedback rules, debt, macroeconomic stabilization

The authors thank Richard Dennis, John Driffill, Martin Ellison, Campbell Leith, Paul Levine, Patrick Minford, Joe Perlman, Alan Sutherland, participants at a conference organized by the Federal Reserve Bank of Atlanta (particularly Eric Leeper, James Nason, Stephanie Schmitt-Grohé, Chris Sims, and Martin Uribe), three referees, and the editor for helpful comments and discussions. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Tatiana Kirsanova, University of Exeter, School of Business and Economics, Streatham Court, Rennes Drive, Exeter, EX4 4PU, United Kingdom, +44 1392-263290, t.kirsanova@exeter.ac.uk, or Simon Wren-Lewis, University of Oxford, Department of Economics, Manor Road, Oxford, OX13UQ, United Kingdom, +44 1865-271080, simon.wren-lewis@economics.ox.ac.uk.

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.