Flexible inflation targeting has been advocated as a practical approach to the implementation of an optimal state-contingent monetary policy, but theoretical expositions reaching this conclusion have typically abstracted from the fiscal consequences of monetary policy. Here we extend the standard theory by considering the character of optimal monetary policy under a variety of assumptions about the fiscal regime, with the standard analysis appearing only as a special case in which non-distorting sources of government revenue exist, and fiscal policy can be relied upon to adjust so as to ensure intertemporal government solvency. Alternative cases treated in this paper assume that there exist only distorting sources of government revenue; that it may not be possible for tax rates to adjust in response to economic disturbances, except with delay; or even that fiscal policy is purely exogenous, so that the central bank cannot rely upon fiscal policy to adjust in order to maintain intertemporal solvency (a case emphasized in the critique of inflation targeting by Sims, 2005). We find that the fiscal policy regime has important consequences for the optimal conduct of monetary policy, but that a suitably modifed form of inflation targeting will still represent a useful approach to the implementation of optimal policy. We derive an optimal targeting rule for monetary policy that applies to all of the fiscal regimes considered in this paper, and show that it involves commitment to an explicit target for an output-gap adjusted price level. The optimal policy will allow temporary departures from the long-run target rate of growth in the gap-adjusted price level in response to disturbances that affect the government's budget, but it will also involve a commitment to rapidly restore the projected growth rate of this variable to its normal level following such disturbances, so that medium-term inflation expectations should remain firmly anchored despite the occurrence of fiscal shocks.
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Paper provided by Columbia University, Department of Economics in its series Discussion Papers with number
0506-09.
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Chari, V.V. & Kehoe, Patrick J., 1999.
"Optimal fiscal and monetary policy,"
Handbook of Macroeconomics,
in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 26, pages 1671-1745
Elsevier.
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