Oikonomou, R., "Optimal Monetary Policy with and without Debt"
Οctober 29, 2021
Title: Optimal Monetary Policy with and without Debt
Speaker: Professor Rigas Oikonomou, Université Catholique de Louvain
Host: Assistant Professor Evangelos Dioikitopoulos, Department of Economics, Athens University of Economics and Business
Abstact: We propose a novel framework of optimal monetary policy in the case where debt sustainability may be a constraint for the central bank. We assume that a monetary authority solves a Ramsey problem under commitment, subject to a set of relevant competitive equilibrium constraints. Depending on the specification of fiscal policy, the constraint set may include the 'consolidated budget constraint'. In particular, if fiscal policy does not generate sufficient surpluses to finance debt then optimal monetary policy must ensure debt sustainability and needs to take into account the constraint. In contrast, if fiscal policy can finance debt through taxes, then the debt constraint is not relevant for monetary policy. We derive optimal interest rate rules in these two cases. Translating the Ramsey outcome into the fiscal theory of the price level framework, we show analytically that when the central bank has to take debt into account optimal policy is a standard 'passive money' rule (e.g. Leeper (1991)).In contrast, when the debt constraint is not relevant for the central bank, optimal monetary policy is 'active'. We then characterise analytically key forces behind optimal policy, exploring the role played by key model variables such as debt maturity and identifying the various channels through which optimal policy responds to shocks. We also explore whether the debt constraint implies significant exposure of inflation to fiscal shocks, when monetary policy is optimal. Finally, we consider several extensions of our framework, including a medium scale DSGE model, and a model with 'regime fluctuations' where the monetary authority may temporarily have to account for debt.