Abstract
We examine fiscal-monetary interactions in a NK DSGE model with deep habit, distortionary taxes and a sovereign risk premium for government debt. Deep habit crucially affects the fiscal transmission mechanism in that it leads to a counter-cyclical mark-up. This feature boosts the size of a output expansion or contraction with important consequences for optimal monetary and fiscal policy. Bayesian estimation gives empirical support for deep as opposed to the more conventional `superficial' habit and our estimated model produces fiscal multipliers in line with estimates from the SVAR literature. We proceed to use the estimated model to compute optimal monetary and fiscal policy first in `normal times' with debt at its steady state and then in a crisis period with a much higher initial debt-GDP ratio. For the former, there is evidence that optimal fiscal adjustment using taxes should be gradual. Impulse responses indicate that the ability of the simple rules to closely mimic the Ramsey optimal policy that we observe with optimal monetary alone is not a feature of optimal policy with two instruments, although the welfare differences are small in consumption equivalent terms. Crisis management consists of a carefully chosen degree of adjustment of fiscal policy towards the optimal long-run rules found for normal times. We find there some support for slow consolidation, especially when government spending only is used, and using tax changes only yields a smaller welfare cost.