Price stability and debt sustainability under endogenous trend growth

This paper studies price stability and debt sustainability when the real rate exceeds trend growth (r > g) in a New Keynesian model with endogenous technology growth through R&D. Under debt-stabilizing ("passive") fiscal policy the Taylor principle is not sufficient for determinacy. Instead, monetary policy should at least aim to raise r − g with persistent inflation in order to stabilize the expectations of households, firms and innovators. Endogenous growth provides a self-financing mechanism for deficits under active fiscal policy; growth provides some backing for the public debt, which reduces the need for debt-stabilizing inflation when current fiscal deficits are not backed by future fiscal surpluses. Because growth creates some fiscal space, a monetary policy that adheres to the Taylor principle combined with active fiscal policy can yield a unique stable equilibrium, provided that the policy permits r−g to fall with inflation.