Hostname: page-component-cd9895bd7-dzt6s Total loading time: 0 Render date: 2024-12-26T07:41:13.018Z Has data issue: false hasContentIssue false
  • English
  • Français

OPTIMAL FISCAL AND MONETARY POLICY, DEBT CRISIS, AND MANAGEMENT

Published online by Cambridge University Press:  20 July 2017

Cristiano Cantore ,
Paul Levine ,
Giovanni Melina  and
Joseph Pearlman
Cristiano Cantore
Affiliation:
University of Surrey
Paul Levine*
Affiliation:
University of Surrey
Giovanni Melina
Affiliation:
International Monetary Fund and City University London
Joseph Pearlman
Affiliation:
City University London
*
Address correspondence to: Paul Levine, School of Economics, University of Surrey, Guildford GU2 7XH, UK; e-mail: p.levine@surrey.ac.uk.
Get access Rights & Permissions [Opens in a new window]

Abstract

The initial government debt-to-gross domestic product (GDP) ratio and the government's commitment play a pivotal role in determining the welfare-optimal speed of fiscal consolidation in the management of a debt crisis. Under commitment, for low or moderate initial government debt-to-GDP ratios, the optimal consolidation is very slow. A faster pace is optimal when the economy starts from a high level of public debt implying high sovereign risk premia, unless these are suppressed via a bailout by official creditors. Under discretion, the cost of not being able to commit is reflected into a quick consolidation of government debt. Simple monetary–fiscal rules with passive fiscal policy, designed for an environment with “normal shocks,” perform reasonably well in mimicking the Ramsey-optimal response to one-off government debt shocks. When the government can issue also long-term bonds—under commitment—the optimal debt consolidation pace is slower than in the case of short-term bonds only, and entails an increase in the ratio between long- and short-term bonds.

Keywords

Optimal Fiscal–Monetary PolicyRamsey PolicyTime-Consistent PolicyOptimized Simple RulesDebt ConsolidationLong-Term DebtFiscal LimitsSovereign Default Risk
Type
Articles
Information
Macroeconomic Dynamics , Volume 23 , Issue 3 , April 2019 , pp. 1166 - 1204
Copyright
Copyright © Cambridge University Press 2017 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

Previous versions of this paper, circulated under the title “Optimal Fiscal and Monetary Rules in Normal and Abnormal Times,” were presented at seminars at the BI Norwegian Business School, the Universities of Loughborough, Oxford Manchester and Reading; at a European Monetary Forum Conference held at the Bank of Greece, “Financial Crisis – Models and Policy Responses,” Athens, 30–31 March 2012; at the conference “Monetary and Fiscal Policy Rules with Labour Market and Financial Frictions,” University of Surrey, 14–15 September 2012; the 6th International Conference on “Computational and Financial Econometrics” (CFE 2012), Oviedo, Spain, 1–3 December 2012; and the Barcelona Summer Forum “Fiscal Sustainability XXI Century,” Barcelona, Spain 9–10 June 2016. Comments by participants at these events are gratefully acknowledged, especially those of a discussant, Katsuyuki Shibayama, at the Surrey Conference and two anonymous referees for their comments and suggestions. All the remaining errors are ours. We also acknowledge financial support from ESRC project RES-062-23-2451. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF or of the IMF board.

References

REFERENCES

Adam, K. (2011) Government debt and optimal monetary and fiscal policy. European Economic Review 55 (1), 57–74.Google Scholar
Andrés, J., López-Salido, J., and Nelson, E. (2004) Tobin's imperfect asset substitution in optimizing general equilibrium. Journal of Money, Credit and Banking 36 (4), 665–91.Google Scholar
Austin, D. and Miller, R. S. (2011) Treasury Securities and the U.S. Sovereign Credit Default Swap Market. Congressional Research Service report for Congress no. 41932.Google Scholar
Batini, N., Callegari, G., and Melina, G. (2012) Successful Austerity in the United States, Europe and Japan. IMF working papers 12/190.Google Scholar
Benigno, P. and Woodford, M. (2004) Optimal monetary and fiscal policy: A linear-quadratic approach. In Gertler, M. and Rogoff, K. (eds.), NBER Macroeconomics Annual 2003, NBER Chapters, pp. 271–364. Cambridge, MA: National Bureau of Economic Research.Google Scholar
Benigno, P. and Woodford, M. (2012) Linear-quadratic approximation of optimal policy problems. Journal of Economic Theory 147 (1), 1–42.Google Scholar
Bi, H., Leeper, E. M., and Leith, C. (2013) Uncertain fiscal consolidations. Economic Journal 123 (566), F31–F63.Google Scholar
Bi, H. and Traum, N. (2014) Estimating fiscal limits: The case of greece. Journal of applied Econometrics 29, 1053–1072.Google Scholar
Blake, A. P. and Kirsanova, T. (2012) Discretionary policy and multiple equilibria in LQ RE models. Review of Economic Studies 79 (4), 1309–1339.Google Scholar
Bouakez, H. and Rebei, N. (2007) Why does private consumption rise after a government spending shock? Canadian Journal of Economics 40 (3), 954–979.Google Scholar
Cantore, C., Levine, P., and Melina, G. (2014) On Habit and Utility-Enhancing Government Consumption. Department of Economics discussion paper series 1406, City University London.Google Scholar
Cantore, C., Levine, P., Melina, G., and Yang, B. (2012) A fiscal stimulus with deep habits and optimal monetary policy. Economics Letters 117 (1), 348–353.Google Scholar
Christiano, L. J., Motto, R., and Rostagno, M. (2014) Risk shocks. American Economic Review 104 (1), 27–65.Google Scholar
Cochrane, J. H. (2011) Determinacy and identification with Taylor rules. Journal of Political Economy 119, 565–615.Google Scholar
Cogan, J. F., T. Cwik, T., Taylor, J. B., and Wieland, V. (2010) New Keynesian versus old Keynesian government spending multipliers. Journal of Economic Dynamics and Control 34 (3), 281–295.Google Scholar
Correia, I., Farhi, E., Nicolini, J. P., and Teles, P. (2013) Unconventional fiscal policy at the zero bound. American Economic Review 103 (4), 1172–1211.Google Scholar
Correia, I., Nicolini, J. P., and Teles, P. (2008) Optimal fiscal and monetary policy: Equivalence results. Journal of Political Economy 116 (1), 141–170.Google Scholar
Corsetti, G., Kuester, K., Meier, A., and Müller, G. J. (2013) Sovereign risk, fiscal policy and macroeconomic stability. Economic Journal 123, F99–132.Google Scholar
Denes, M., Eggertsson, G. B., and Gilbukh, S. (2013) Deficits, public debt dynamics and tax and spending multipliers. Economic Journal 123 (566), F133–F163.Google Scholar
Dennis, R. and Kirsanova, T. (2013) Expectations Traps and Coordination Failures with Discretionary Policymaking. Working papers 2013 02, Business School – Economics, University of Glasgow.Google Scholar
Dennis, R. and Kirsanova, T. (2015) Computing time-consistent markov-perfect optimal policies in business-cycle models. Macroeconomic Dynamics 20 (7), 1850–1872.Google Scholar
Erceg, C. J. and Linde, J. (2013) Fiscal consolidation in a currency union: Spending cuts vs. tax hikes. Journal of Economic Dynamics and Control 37 (2), 422–445.Google Scholar
Furlanetto, F. (2011) Fiscal stimulus and the role of wage rigidity. Journal of Economic Dynamics and Control 35 (4), 512–527.Google Scholar
Giannoni, M. (2014) Optimal interest-rate rules and inflation stabilization vs. price-level stabilization. Journal of Economic Dynamics and Control 41 (C), 110–129.Google Scholar
Harrison, R. (2012) Asset Purchase Policy at the Effective Lower Bound for Interest Rates. Bank of England working papers 444.Google Scholar
Jaimovich, N. and Rebelo, S. (2008) News and business cycles in open economies. Journal of Money, Credit and Banking 40 (8), 1699–1711.Google Scholar
Kirsanova, T., Leith, C., and Wren-Lewis, S. (2009) Monetary and fiscal policy interaction: The current consensus assignment in the light of recent developments. Economic Journal 119 (541), F482–F496.Google Scholar
Kirsanova, T. and Wren-Lewis, S. (2012) Optimal fiscal feedback on debt in an economy with nominal rigidities. Economic Journal 122 (559), 238–264.Google Scholar
Leeper, E. M. (1991) Equilibria under active and passive monetary and fiscal policies. Journal of Monetary Economics 27, 129–147.Google Scholar
Leeper, E. M., Plante, M., and Traum, N. (2010) Dynamics of fiscal financing in the United States. Journal of Econometrics 156 (2), 304–321.Google Scholar
Leith, C., Moldovan, I., and Rossi, R. (2012) Optimal monetary policy in a New Keynesian model with habits in consumption. Review of Economic Dynamics 15 (3), 416–435.Google Scholar
Leith, C. and Wren-Lewis, S. (2013) Fiscal sustainability in a New Keynesian model. Journal of Money, Credit and Banking 45 (8), 1477–1516.Google Scholar
Levine, P., McAdam, P., and Pearlman, J. (2008a) Quantifying and sustaining welfare gains from monetary commitment. Journal of Monetary Economics 55 (7), 1253–1276.Google Scholar
Levine, P. and Pearlman, J. (2011) Computation of LQ Approximations to Optimal Policy Problems in Different Information Settings under Zero Lower Bound Constraints. Dynare working paper 10, CEPREMAP.Google Scholar
Levine, P., Pearlman, J., and Pierse, R. (2008b) Linear-quadratic approximation, external habit and targeting rules. Journal of Economic Dynamics and Control 32 (10), 3315–3349.Google Scholar
Michal, H. (2011) Alternative perspectives on optimal public debt adjustment. B.E. Journal of Macroeconomics 11 (1), 1–22.Google Scholar
Ostry, J. D., Ghosh, A. R., and Espinoza, R. A. (2015) When Should Public Debt be Reduced? IMF Staff discussion notes 15/10.Google Scholar
Pappa, E. (2009) The effects of fiscal shocks on employment and the real wage. International Economic Review 50 (1), 217–244.Google Scholar
Rotemberg, J. J. (1982) Monopolistic price adjustment and aggregate output. Review of Economic Studies 49 (4), 517–31.Google Scholar
Schmitt-Grohe, S. and Uribe, M. (2004a) Optimal fiscal and monetary policy under sticky prices. Journal of Economic Theory 114, 198–230.Google Scholar
Schmitt-Grohe, S. and Uribe, M. (2004b) Solving dynamic general equilibrium models using a second-order approximation to the policy function. Journal of Economic Dynamics and Control 28, 755–775.Google Scholar
Schmitt-Grohe, S. and Uribe, M. (2007) Optimal simple and implementable monetary and fiscal rules. Journal of Monetary Economics 54 (6), 1702–1725.Google Scholar
Sims, C. A. (2013) Paper money. American Economic Review 103 (2), 563–584.Google Scholar
Siu, H. E. (2004) Optimal fiscal and monetary policy with sticky prices. Journal of Monetary Economics 51 (3), 575–607.Google Scholar
Smets, F. and Wouters, R. (2007) Shocks and frictions in US business cycles: A Bayesian DSGE approach. American Economic Review 97 (3), 586–606.Google Scholar
Taylor, J. B. (1993) Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39, 195–214.Google Scholar
Woodford, M. (2003) Foundations of a Theory of Monetary Policy. Princeton: Princeton University Press.Google Scholar
Zubairy, S. (2014) On fiscal multipliers: Estimates from a medium scale DSGE model. International Economic Review 55 (1), 169–195.Google Scholar