Optimal Fiscal and Monetary Policy Under Sticky Prices

31 Pages Posted: 16 Jul 2001

See all articles by Stephanie Schmitt-Grohé

Stephanie Schmitt-Grohé

Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: July 18, 2001

Abstract

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 exogenous 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 (i.e., 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 behavior 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.

Keywords: Optimal Fiscal and Monetary Policy, Sticky Prices, Optimal Inflation Volatility, Tax Smoothing

JEL Classification: E52, E61, E63

Suggested Citation

Schmitt-Grohe, Stephanie and Uribe, Martin, Optimal Fiscal and Monetary Policy Under Sticky Prices (July 18, 2001). Available at SSRN: https://ssrn.com/abstract=275809 or http://dx.doi.org/10.2139/ssrn.275809

Stephanie Schmitt-Grohe (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER)

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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212-851-4008 (Phone)
212-854-8059 (Fax)

National Bureau of Economic Research (NBER)

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United States

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