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Optimal monetary and fiscal policy: a linear-quadratic approach

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Author Info
Pierpaolo Benigno
Michael Woodford

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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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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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Related research
Keywords: Monetary policy Fiscal policy

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This paper has been announced in the following NEP Reports: 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.:
  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.
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  2. 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. [Downloadable!] (restricted)
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  3. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2002. "Optimal Monetary Policy," NBER Working Papers 9402, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December. [Downloadable!] (restricted)
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  6. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings, Federal Reserve Bank of Kansas City, pages 277-316. [Downloadable!]
  7. 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(2000-2), pages 253-302. [Downloadable!]
  8. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," Levine's Bibliography 506439000000000384, UCLA Department of Economics. [Downloadable!]
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  9. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October. [Downloadable!] (restricted)
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  10. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
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  11. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December. [Downloadable!] (restricted)
  13. 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. [Downloadable!] (restricted)
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  14. 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. [Downloadable!]
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  15. Martin Uribe & Stephanie Schmitt-Grohe, 2001. "Optimal fiscal and monetary policy under sticky prices," Proceedings, Federal Reserve Bank of San Francisco, issue Jun. [Downloadable!]
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  16. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April. [Downloadable!] (restricted)
  17. 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. [Downloadable!]
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  18. 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. [Downloadable!] (restricted)
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  19. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 426-477, June.
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  20. Svensson, Lars E. O., 1999. "Inflation targeting as a monetary policy rule," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 607-654, June. [Downloadable!] (restricted)
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  21. Lars E. O. Svensson & Michael Woodford, 2003. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Working Papers 9747, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  22. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Inflation Targeting Rules," NBER Working Papers 9939, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  23. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky information versus sticky prices: a proposal to replace the New-Keynesian Phillips Curve," Proceedings, Federal Reserve Bank of San Francisco, issue Jun. [Downloadable!]
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  24. 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. [Downloadable!] (restricted)
  25. 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. [Downloadable!] (restricted)
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