Fiscal Rules, Interest Payments on Debt, and the Irrelevance of the Taylor Principle

We show that in New Keynesian models with non‐neutral government debt, the Taylor principle ceases to be relevant for equilibrium determinacy if the government follows a fiscal rule of levying taxes in proportion to its interest payments on existing debt. This is in contrast with previous studies, w...

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Bibliographic Details
Published in:Scottish journal of political economy 2012-07, Vol.59 (3), p.250-265
Main Authors: Linnemann, Ludger, Schabert, Andreas
Format: Article
Language:English
Subjects:
Deficit financing
Economic models
Interest
Keynesian theory
Keynesianism
Monetary policy
Political economy
Public debt
Studies
Taxation
Taxes
Taylor rule
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Summary:We show that in New Keynesian models with non‐neutral government debt, the Taylor principle ceases to be relevant for equilibrium determinacy if the government follows a fiscal rule of levying taxes in proportion to its interest payments on existing debt. This is in contrast with previous studies, which typically have assumed that taxes respond to the level of debt, and have found either a confirmation or reversal of the Taylor principle depending on the feedback from debt to taxes. We find, instead, that the equilibrium effect of the interest rate on debt is crucial for determinacy. If, as in our model, taxes are raised in response to debt interest payments, the range of indeterminacy monotonically decreases with the fiscal feedback parameter. When interest payments are completely tax‐financed, indeterminacy is ruled out without any restrictions on monetary policy.
ISSN:0036-9292
1467-9485
DOI:10.1111/j.1467-9485.2012.00579.x