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Optimal Fiscal and Monetary Policy with Sticky Wages and Sticky Prices

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  • Sanjay K. Chugh

    (Board of Governors of the Federal Reserve)

Abstract

We determine the optimal degree of price inflation volatility when nominal wages are sticky and the government uses state-contingent inflation to finance government spending. We address this question in a well-understood Ramsey model of fiscal and monetary policy, in which the benevolent planner has access to labor income taxes, nominally risk-free debt, and money creation. Our main result is that sticky wages alone make price stability optimal in the face of shocks to the government budget, to a degree quantitatively similar as sticky prices alone. Key for our results is an equilibrium restriction between nominal price inflation and nominal wage inflation that holds trivially in a Ramsey model featuring only sticky prices. Our results thus show that when nominal wages are sticky, setting real wages as close as possible to their efficient path is a more important goal of optimal monetary policy than is financing innovations in the government budget via state-contingent inflation. A second important result is that the nominal interest rate can be used to indirectly tax the rents of monopolistic labor suppliers. Taken together, our results uncover features of Ramsey fiscal and monetary policy in the presence of a type of labor market imperfection that is widely-believed to be important. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2006.07.001
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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 9 (2006)
Issue (Month): 4 (October)
Pages: 683-714

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Handle: RePEc:red:issued:05-136

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Related research

Keywords: Optimal fiscal and monetary policy; Sticky wages; Sticky prices; Friedman Rule; Ramsey problem;

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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  2. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
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  11. Stephanie Schmitt-Grohé & Martín Uribe, 2006. "Optimal Fiscal and Monetary Policy in a Medium-Scale Macroeconomic Model," NBER Chapters, in: NBER Macroeconomics Annual 2005, Volume 20, pages 383-462 National Bureau of Economic Research, Inc.
  12. David M. Arseneau & Sanjay K. Chugh, 2006. "Ramsey Meets Hosios: The Optimal Capital Tax and Labor Market Efficiency," 2006 Meeting Papers 568, Society for Economic Dynamics.
  13. Andrew T. Levin & Alexei Onatski & John C. Williams & Noah Williams, 2005. "Monetary Policy Under Uncertainty in Micro-Founded Macroeconometric Models," NBER Working Papers 11523, National Bureau of Economic Research, Inc.
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