Optimal Fiscal and Monetary Policy Under Sticky Prices
Duke University - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)
CEPR Discussion Paper No. 2942
This Paper studies optimal fiscal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy without capital. The government finances an exogeneous stream of purchases by levying distortionary income taxes, printing money, and issuing one-period nominally risk-free bonds. The main findings of the Paper are: First, for a miniscule degree of price stickiness (ie. many times below available empirical estimates) the optimal volatility of inflation is near zero. This result stands in stark contrast with the high volatility of inflation implied by the Ramsey allocation when prices are flexible. The finding is in line with a recent body of work on optimal monetary policy under nominal rigidities that ignores the role of optimal fiscal policy. Second, even small deviations from full price flexibility induce near random walk behaviour in government debt and tax rates, as in economies with real non-state-contingent debt only. Finally, sluggish price adjustment raises the average nominal interest rate above the one called for by the Friedman rule.
Number of Pages in PDF File: 34
Keywords: Optimal fiscal and monetary policy, sticky prices, optimal inflation volatility, tax smoothing
JEL Classification: E52, E61, E63working papers series
Date posted: September 6, 2001
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