Optimal Fiscal and Monetary Policy with Nominal and Indexed Debt

Abstract

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.

Keywords: Ramsey policy, Optimal monetary policy, Optimal taxation

JEL Classification: E44, E63, H63