Optimal Simple and Implementable Monetary and Fiscal Rules

53 Pages Posted: 5 May 2004

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: March 2004

Abstract

The goal of this Paper is to compute optimal monetary and fiscal policy rules in a real business cycle model augmented with sticky prices, a demand for money, taxation, and stochastic government consumption. We consider simple policy rules, whereby the nominal interest rate is set as a function of output and inflation, and taxes are set as a function of total government liabilities. We require policy to be implementable in the sense that it guarantees uniqueness of equilibrium. We do away with a number of empirically unrealistic assumptions typically maintained in the related literature that are used to justify the computation of welfare using linear methods. Instead, we implement a second-order accurate solution to the model. Our main findings are: First, the size of the inflation coefficient in the interest-rate rule plays a minor role for welfare. It matters only insofar as it affects the determinacy of equilibrium. Second, optimal monetary policy features a muted response to output. More importantly, interest rate rules that feature a positive response of the nominal interest rate to output can lead to significant welfare losses. Third, the optimal fiscal policy is passive. The welfare losses associated with the adoption of an active fiscal stance are, however, negligible.

Keywords: Optimal fiscal and monetary policy, nominal rigidities, optimal inflation volatility, second-order approximation techniques

JEL Classification: E52, E61, E63

Suggested Citation

Schmitt-Grohe, Stephanie and Uribe, Martin, Optimal Simple and Implementable Monetary and Fiscal Rules (March 2004). CEPR Discussion Paper No. 4334. Available at SSRN: https://ssrn.com/abstract=540281

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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Cambridge, MA 02138
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Martin Uribe

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

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New York, NY 10027
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212-851-4008 (Phone)
212-854-8059 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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