Monetary Policy, Taxes, and the Business Cycle

FRB of St. Louis Working Paper No. 2004-017B

44 Pages Posted: 29 Jul 2005

See all articles by William T. Gavin

William T. Gavin

Federal Reserve Bank of St. Louis - Research Division; University of Memphis Department of Economics

Finn Kydland

Carnegie Mellon University - David A. Tepper School of Business; Norwegian School of Economics (NHH) - Department of Economics

Michael R. Pakko

Arkansas Economic Development Institute

Date Written: May 2006

Abstract

In this paper, we model the interaction of inflation with the tax on nominal capital gains, examining the contribution of this interaction to aggregate fluctuations. Our innovation is to combine monetary policy shocks with non-indexed taxes in a model in which the central bank implements policy using an interest rate rule. Monetary policy shocks enter as persistent shocks to the inflation objective. The use of an interest rate rule makes these shocks highly persistent, leading to persistent changes in the expected marginal tax rate on capital gains. We find that monetary policy had important effects on the behavior of the business cycle before 1980 because the shocks to inflation were large and persistent. Monetary policy reform around 1980 led to a decline in persistence of shocks to inflation. With this lower persistence, the effect of the interaction between monetary policy and the nominal capital gains tax becomes negligible.

Keywords: Inflation, taxation, business cycle

JEL Classification: E31, E32, E42

Suggested Citation

Gavin, William T. and Kydland, Finn E. and Pakko, Michael R., Monetary Policy, Taxes, and the Business Cycle (May 2006). FRB of St. Louis Working Paper No. 2004-017B, Available at SSRN: https://ssrn.com/abstract=761968 or http://dx.doi.org/10.2139/ssrn.761968

William T. Gavin (Contact Author)

Federal Reserve Bank of St. Louis - Research Division ( email )

441 Locust Street
P. O. Box 442
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HOME PAGE: http://www.gavinecon.com

University of Memphis Department of Economics ( email )

Memphis, TN 38152
United States

Finn E. Kydland

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
412 268-3691 (Phone)
412 268-7357 (Fax)

Norwegian School of Economics (NHH) - Department of Economics

Helleveien 30
N-5035 Bergen
Norway

Michael R. Pakko

Arkansas Economic Development Institute ( email )

2801 South University Avenue
Little Rock, AR 72204
United States
501-569-8541 (Phone)
501-569-8538 (Fax)

HOME PAGE: http://https://ualr.edu/aedi/

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