Optimal fiscal and monetary policy, debt crisis, and management

Cantore, C. M., Levine, P., Melina, G. & Pearlman, J. (2017). Optimal fiscal and monetary policy, debt crisis, and management. Macroeconomic Dynamics, doi: 10.1017/S1365100517000207

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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.

Item Type: Article
Additional Information: This article has been published in a revised form in 'Macroeconomic dynamics' https://0-doi-org.wam.city.ac.uk/10.1017/S1365100517000207. This version is free to view and download for private research and study only. Not for re-distribution, re-sale or use in derivative works. © 2017 Cambridge University Press.
Uncontrolled Keywords: Optimal fiscal-monetary policy, Ramsey policy, time-consistent policy, optimised simple rules, debt consolidation, long-term debt, fiscal limits, sovereign default risk.
Divisions: School of Social Sciences > Department of Economics
URI: http://openaccess.city.ac.uk/id/eprint/18743

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