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The research catalogue is an archive of ESRC-funded grants and outputs. Links, files and other content will no longer be maintained or updated after April 2014.

New Directions in Monetary and Fiscal Policy Analysis at the Macroeconomic Level

Grant reference: RES-062-23-1436

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Fiscal sustainability in a new Keynesian model
Recent work has added government debt and distortionary taxes into New Keynesian models, and analysed optimal fiscal and monetary policy when social welfare is derived from consumers' utility. These papers have shown that, if policy makers can commit to a time inconsistent policy, steady-state debt will follow a random walk. In this paper we consider the nature of the time-inconsistency involved and its implication for discretionary policy-making. We show that governments are tempted, given inflationary expectations, to utilise 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 (e¢ cient) debt level. This implies that under a discretionary policy the random walk result is overturned: debt will always be returned to this initial steady-state even although 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 stabilise 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 in a repeated game and find that at high debt-gdp ratios and extremes of price stickiness/flexibility the commitment equilibrium may not be credible.

Primary contributor

Author Campbell Leith

Additional contributors

Co-author Simon Wren-Lewis

Additional details

University of Glasgow
01 May 2010


Cite this outcome


Leith, Campbell and Wren-Lewis, Simon (2010) Fiscal sustainability in a new Keynesian model. Glasgow: University of Glasgow.


Leith Campbell and Wren-Lewis Simon. Fiscal sustainability in a new Keynesian model. Glasgow: University of Glasgow, 2010.