Electoral Uncertainty and the Deficit Bias in a New Keynesian Economy

Recent attempts to incorporate optimal fiscal policy into New Keynesian models subject to nominal inertia, have tended to assume that policy makers are benevolent and have access to a commitment technology. A separate literature, on the New Political Economy, has focused on real economies where there is strategic use of policy instruments in a world of political conflict. In this paper we combine these literatures and assume that policy is set in a New Keynesian economy by one of two policy makers facing electoral uncertainty (in terms of infrequent elections and an endogenous voting mechanism). The policy makers generally share the social welfare function, but differ in their preferences over fiscal expenditure (in its size and/or composition). Given the environment, policy shall be realistically constrained to be time-consistent. In a sticky-price economy, such heterogeneity gives rise to the possibility of one policy maker utilising (nominal) debt strategically to tie the hands of the other party, and influence the outcome of any future elections. This can give rise to a deficit bias, implying a sub-optimally high level of steady-state debt, and can also imply a sub-optimal response to shocks. The steady-state distortions and inflation bias this generates, combined with the volatility induced by the electoral cycle in a sticky-price environment, can significantly

When is Monetary Policy All we Need?

We consider optimal monetary and scal policies in a New Keynesian model of a small open economy with sticky prices and wages. In this benchmark setting monetary policy is all we need - analytical results demonstrate that variations in government spending should play no role in the stabilization of shocks. In extensions we show, rstly, that this is even when true when allowing for in ation inertia through backward-looking rule-of-thumb price and wage-setting, as long as there is no discrepancy between the private and social evaluation of the marginal rate of substitution between consumption and leisure. Secondly, the optimal neutrality of government spending is robust to the issuance of public debt. In the presence of debt government spending will deviate from the optimal steady-state but only to the extent required to cover the deficit, not to provide any additional macroeconomic stabilization. However, unlike government spending variations in tax rates can play a complementary role to monetary policy, as they change relative prices rather than demand.

Discretionary Policy in a Monetary Union with Sovereign Debt

This paper examines the interactions between multiple national fiscal policy- makers and a single monetary policy maker in response to shocks to government debt in some or all of the countries of a monetary union. We assume that national governments respond to excess debt in an optimal manner, but that they do not have access to a commitment technology. This implies that national fi scal policy gradually reduces debt: the lack of a commitment technology precludes a random walk in steady state debt, but the need to maintain national competitiveness avoids excessively rapid debt reduction. If the central bank can commit, it adjusts its policies only slightly in response to higher debt, allowing national fiscal policy to undertake most of the adjustment. However if it cannot commit, then optimal monetary policy involves using interest rates to rapidly reduce debt, with signifi cant welfare costs. We show that in these circumstances the central bank would do better to ignore national fiscal policies in formulating its policy.

Fiscal Sustainability in a New Keynesian Model

Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady-state debt to follow a random walk. Leith and Wren-Lewis (2012) consider the nature of the timeinconsistency involved in such a policy and its implication for discretionary policy-making. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government’s objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt-stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi-commitment policy which allows for different probabilities of reneging on past promises. This on-line Appendix extends the results of this paper.

Fiscal Sustainability in a New Keynesian Model

Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady-state debt to follow a random walk. Leith and Wren-Lewis (2012) consider the nature of the timeinconsistency involved in such a policy and its implication for discretionary policy-making. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government’s objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt-stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi-commitment policy which allows for different probabilities of reneging on past promises. This on-line Appendix extends the results of this paper.