Optimal Fiscal and Monetary Policy, Debt Crisis and Management

IMF Working Papers, March 30, 2017

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Optimal Fiscal and Monetary Policy, Debt Crisis and Management

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Bibliographic details

• Authors: Cristiano Cantore, Paul L Levine, Giovanni Melina, Joseph G Pearlman
• Published: March 30, 2017
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781475590180.001

Summary of core findings

• The initial government debt-to-GDP ratio and the government’s commitment are pivotal in determining the welfare-optimal speed of fiscal consolidation in managing 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.
  • When the government can issue long-term bonds, 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.
• Under discretion:
  • The cost of not being able to commit is reflected in a quick consolidation of government debt.
• Policy rules:
  • 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.

Policy implications and recommendations

• Assess initial government debt-to-GDP ratio explicitly when designing consolidation strategies; low/moderate ratios justify very slow consolidation under commitment.
• Anticipate quicker consolidation needs when initial public debt is high and sovereign risk premia are elevated, unless an official bailout reduces premia.
• Prioritize commitment mechanisms to avoid the faster consolidation pressure that arises under discretion.
• Consider allowing issuance of long-term bonds as a tool to slow optimal consolidation pace and re-balance the maturity structure toward a higher long-to-short bond ratio, under commitment.
• Utilize simple monetary-fiscal rules with passive fiscal policy as practical approximations to Ramsey-optimal responses for one-off debt shocks in environments characterized by “normal shocks”.

Content in this bundle

• Optimal Fiscal and Monetary Policy, Debt Crisis and Management, WP/17/78, March 2017
  • Optimal Fiscal and Monetary Policy, Debt Crisis and Management, WP/17/78, March 2017 (Markdown version)
  • Optimal Fiscal and Monetary Policy, Debt Crisis and Management, WP/17/78, March 2017 (PDF)