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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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  1. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers 481, Society for Economic Dynamics.
  2. Argia M. Sbordone, 2001. "Prices and Unit Labor Costs: A New Test of Price Stickiness," Departmental Working Papers 199822, Rutgers University, Department of Economics.
  3. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, pages 519-546.
  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. 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.
  6. 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.
  7. 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.
  8. Svensson, Lars E. O., 1998. "Inflation targeting as a monetary policy rule," CFS Working Paper Series 1998/16, Center for Financial Studies (CFS).
  9. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
  10. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
  11. Marc Giannoni & Michael Woodford, 2004. "Optimal Inflation-Targeting Rules," NBER Chapters, in: The Inflation-Targeting Debate, pages 93-172 National Bureau of Economic Research, Inc.
  12. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2003. "Optimal Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 825-860, October.
  13. 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.
  14. Woodford Michael, 2002. "Inflation Stabilization and Welfare," The B.E. Journal of Macroeconomics, De Gruyter, vol. 2(1), pages 1-53, February.
  15. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  16. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December.
  17. 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.
  18. 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.
  19. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  20. 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.
  21. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  22. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," CEPR Discussion Papers 2942, C.E.P.R. Discussion Papers.
  23. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
  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. 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.
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