Political shocks and public debt: The case for a conservative central bank revisited

We explore the dynamics of public debt and optimal institutions in the presence of political shocks arising from electoral uncertainty. Under commitment, optimal stabilization is established by combining an inflation target with a debt target. The inflation target should be contingent on the political shocks while the debt target forces the government to fully absorb the political shocks in the period in which it occurs. In the absence of such inflation and debt targets but with monetary commitment, a conservative central bank enhances stabilization. An even more conservative central bank is optimal if monetary policy cannot commit.

Keywords: Political shocks; Public debt; Commitment; Discretion; Central bank conservatism; Targets

JEL classification codes: E52; E58; E61; E62