Optimal fiscal and monetary policy with preference over safe assets

This paper investigates optimal fiscal and monetary policy in a New-Keynesian model with preferences over safe assets (POSA). Relative to a model with standard preferences, a Ramsey planner facing POSA uses inflation more actively to absorb the effects of fiscal and demand shocks despite inflation being costly. The optimal response of inflation to the shocks thus departs from the traditional prescription observed in standard New-keynesian models with sticky prices in which inflation volatility is near zero. Moreover, under POSA taxes are not as smooth as under standard preferences and are more frontloaded, an outcome that brings the model closer to optimal policy under flexible prices. With POSA, debt issuance depresses the liquidity premium, reducing revenues collected by the government and tightening the budget constraint. Therefore the planner is much less willing to issue debt in response to (say) a fiscal shock, which explains the excess tax volatility observed. These results do not dramatically change when private capital is introduced to the economy, the planner stills finds optimal to use inflation to absorb the shocks. Moreover in spite of the fact that debt issuance is lower private investment is still crowded out under POSA due to the higher distortionary taxes. Finally, the planner faced with POSA outperforms the New-Keynesian planner (with standard preferences) in terms of stabilizing the economy to a negative demand disturbance, but underperforms in terms of managing the government spending shock. The negative demand shock increases the demand for government debt and relaxes the tradeoff facing the planner. The opposite holds in the case of a spending shock.