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Optimal monetary and fiscal policy: a linear-quadratic approach

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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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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 806.

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Date of creation: 2004
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Handle: RePEc:fip:fedgif:806

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Keywords: Monetary policy ; Fiscal policy;

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References

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  1. Pierpaolo Benigno & Michael Woodford, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," NBER Working Papers 10838, National Bureau of Economic Research, Inc.
  2. Argia M. Sbordone, 2001. "Prices and Unit Labor Costs: A New Test of Price Stickiness," Departmental Working Papers 200112, Rutgers University, Department of Economics.
  3. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
  4. Lars E. O. Svensson & Michael Woodford, 2003. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Working Papers 9747, National Bureau of Economic Research, Inc.
  5. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  6. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
  7. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Inflation Targeting Rules," NBER Working Papers 9939, National Bureau of Economic Research, Inc.
  8. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2002. "Optimal Monetary Policy," NBER Working Papers 9402, National Bureau of Economic Research, Inc.
  9. 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.
  10. Svensson, Lars E. O., 1999. "Inflation targeting as a monetary policy rule," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 607-654, June.
  11. Woodford Michael, 2002. "Inflation Stabilization and Welfare," The B.E. Journal of Macroeconomics, De Gruyter, vol. 2(1), pages 1-53, February.
  12. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
  13. 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.
  14. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
  15. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Optimal Fiscal and Monetary Policy Under Sticky Prices," NBER Working Papers 9220, National Bureau of Economic Research, Inc.
  16. 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.
  17. 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.
  18. Isabel Correia & Juan Pablo Nicolini & Pedro Teles, 2002. "Optimal fiscal and monetary policy: equivalence results," Working Paper Series WP-02-16, Federal Reserve Bank of Chicago.
  19. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
  20. 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.
  21. Chari, V V & Christiano, Lawrence J & Kehoe, Patrick J, 1994. "Optimal Fiscal Policy in a Business Cycle Model," Journal of Political Economy, University of Chicago Press, vol. 102(4), pages 617-52, August.
  22. 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.
  23. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
  24. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
  25. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December.
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