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A Fiscal Theory of Monetary Policy with Partially-Repaid Long-Term Debt

John H. Cochrane

NBER Working Paper No. 26745
Issued in February 2020
NBER Program(s):Asset Pricing Program, Economic Fluctuations and Growth Program, Monetary Economics Program

I construct a simple model with sticky prices and interest rate targets, closed by fiscal theory of the price level with long-term debt and fiscal and monetary policy rules. Fiscal surpluses rise following periods of deficit, to repay accumulated debt, but surpluses do not respond to arbitrary unexpected inflation and deflation, so fiscal policy remains active. This specification avoids many puzzles and counterfactual predictions of standard active-fiscal specifications. The model produces reasonable responses to fiscal and monetary policy shocks, including smooth and protracted disinflation following monetary or fiscal tightening.

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Document Object Identifier (DOI): 10.3386/w26745

 
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