Optimal Fiscal and Monetary Policy with Nominal and Indexed Debt
IMF Working Papers, November 1, 2003
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- Optimal Fiscal and Monetary Policy with Nominal and Indexed Debt
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Bibliographic details
- Authors: Thomas F. Cosimano, Michael T. Gapen
- Published: November 1, 2003
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451875379.001
Summary
- This paper highlights the importance of debt composition in setting optimal fiscal and monetary policy over short-run business cycles and in the long run.
- Nominal debt as state-contingent debt can be a significant policy tool to reduce the volatility of distortionary government policy, thereby reducing macroeconomic volatility while increasing equilibrium output and consumption.
- The welfare gain from using nominal debt to hedge against shocks to the government budget is as large as the welfare gain from the ability to issue debt.
Key Findings
- Debt composition matters for both short-run business cycles and long-run policy outcomes.
- Nominal debt functions as state-contingent debt and can be used to hedge government budget shocks.
- Using nominal debt to hedge budget shocks reduces the volatility of distortionary government policy.
- Reduced policy volatility translates into lower macroeconomic volatility and higher equilibrium output and consumption.
- The welfare gain from hedging with nominal debt equals the welfare gain from the ability to issue debt.
Policy Implications
- Design of fiscal and monetary policy should incorporate debt composition as a policy variable.
- Issuance choices between nominal and indexed debt can be used proactively to stabilize macroeconomic outcomes.
- Policymakers can achieve welfare improvements comparable to those from access to debt markets by exploiting nominal debt’s state-contingent properties.