Interest rate policy, debt, and indeterminacy with distortionary taxation

The interest rate setting policy of the central bank influences the amount of funds the government must raise to pay the interest on its existing debt. With distortionary taxation, fiscal adjustments feed back on the model's endogenous variables. The conditions under which interest rate and tax policies are compatible with a uniquely determined stable equilibrium are derived for an optimizing sticky-price model. If the fiscal government continuously balances its budget, active interest rate policy easily leads to indeterminacy if there is a positive steady-state stock of public debt. When short-run deficits are allowed, active interest rate policy and determinacy are compatible unless the tax rate is too strongly increasing in response to changes in debt, the real interest rate, or output.