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Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach

In: NBER Macroeconomics Annual 2003, Volume 18

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  • Pierpaolo Benigno
  • Michael Woodford

Abstract

We propose an integrated treatment of the problems of optimal monetary and fiscal policy, for an economy in which prices are sticky (so that the supply-side effects of tax changes are more complex than in standard fiscal analyses) and the only available sources of government revenue are distorting taxes (so that the fiscal consequences of monetary policy must be considered alongside the usual stabilization objectives). Our linear-quadratic approach allows us to nest both conventional analyses of optimal monetary stabilization policy and analyses of optimal tax-smoothing as special cases of our more general framework. We show how a linear-quadratic policy problem can be derived which yields a correct linear approximation to the optimal policy rules from the point of view of the maximization of expected discounted utility in a dynamic stochastic general-equilibrium model. Finally, in addition to characterizing the optimal dynamic responses to shocks under an optimal policy, we derive policy rules through which the monetary and fiscal authorities may implement the optimal equilibrium. These take the form of optimal targeting rules, specifying an appropriate target criterion for each authority.

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This chapter was published in:

  • Mark Gertler & Kenneth Rogoff, 2004. "NBER Macroeconomics Annual 2003, Volume 18," NBER Books, National Bureau of Economic Research, Inc, number gert04-1, October.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 11445.

    Handle: RePEc:nbr:nberch:11445

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    1. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
    2. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2001. "Optimal monetary policy," Working Papers 01-5, Federal Reserve Bank of Philadelphia.
    3. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Inflation Targeting Rules," NBER Working Papers 9939, National Bureau of Economic Research, Inc.
    4. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
    5. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
    6. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
    7. Svensson, Lars E. O., 1998. "Inflation targeting as a monetary policy rule," CFS Working Paper Series 1998/16, Center for Financial Studies (CFS).
    8. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
    9. Isabel Correia & Juan Pablo Nicolini & Pedro Teles, 2008. "Optimal fiscal and monetary policy: equivalence results," Staff Report 403, Federal Reserve Bank of Minneapolis.
    10. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
    11. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
    12. Sbordone, Argia M., 2002. "Prices and unit labor costs: a new test of price stickiness," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 265-292, March.
    13. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    14. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under sticky prices," Journal of Economic Theory, Elsevier, vol. 114(2), pages 198-230, February.
    15. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal fiscal policy in a business cycle model," Staff Report 160, Federal Reserve Bank of Minneapolis.
    16. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc.
    17. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
    18. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Staff Report 147, Federal Reserve Bank of Minneapolis.
    19. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    20. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December.
    21. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
    22. George J. Hall & Stefan Krieger, 2000. "Tax Smoothing Implications of the Federal Debt Paydown," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 31(2), pages 253-302.
    23. Svensson, Lars E O & Woodford, Michael, 2004. "Implementing Optimal Policy Through Inflation-Forecast Targeting," CEPR Discussion Papers 4229, C.E.P.R. Discussion Papers.
    24. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
    25. Bernheim, B Douglas, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 540-42, August.
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