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Optimal fiscal and monetary policy, debt crisis, and management

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

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.

Publication 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.
Publisher Keywords: Optimal fiscal-monetary policy, Ramsey policy, time-consistent policy, optimised simple rules, debt consolidation, long-term debt, fiscal limits, sovereign default risk.
Departments: School of Arts & Social Sciences > Economics
URI: http://openaccess.city.ac.uk/id/eprint/18743
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