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Distortionary fiscal policy and monetary policy goals

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  • Klaus Adam
  • Roberto M. Billi

Abstract

We study interactions between monetary policy, which sets nominal interest rates, and fiscal policy, which levies distortionary income taxes to finance public goods, in a standard, sticky-price economy with monopolistic competition. Policymakers? inability to commit in advance to future policies gives rise to excessive inflation and excessive public spending, resulting in welfare losses equivalent to several percent of consumption each period. We show how appointing a conservative monetary authority, which dislikes inflation more than society does, can considerably reduce these welfare losses and that optimally the monetary authority is predominantly concerned about inflation. Full conservatism, i.e., exclusive concern about inflation, entirely eliminates the welfare losses from discretionary monetary and fiscal policymaking, provided monetary policy is determined after fiscal policy each period. Full conservatism, however, is severely suboptimal when monetary policy is determined simultaneously with fiscal policy or before fiscal policy each period.

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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 10-10.

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Date of creation: 2010
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Handle: RePEc:fip:fedkrw:rwp10-10

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  1. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  2. Eric Maskin & Jean Tirole, 1997. "Markov Perfect Equilibrium, I: Observable Actions," Harvard Institute of Economic Research Working Papers 1799, Harvard - Institute of Economic Research.
  3. Javier Díaz-Giménez & Giorgia Giovannetti & Ramon Marimon & Pedro Teles, 2004. "Nominal debt as a burden on monetary policy," Working Paper Series WP-04-10, Federal Reserve Bank of Chicago.
  4. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," CEPR Discussion Papers 2942, C.E.P.R. Discussion Papers.
  5. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
  6. Adam, Klaus & Billi, Roberto M, 2006. "Monetary Conservatism and Fiscal Policy," CEPR Discussion Papers 5740, C.E.P.R. Discussion Papers.
  7. Robert J. Barro & David B. Gordon, 1983. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  8. Adam, Klaus, 2011. "Government debt and optimal monetary and fiscal policy," European Economic Review, Elsevier, vol. 55(1), pages 57-74, January.
  9. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  10. Niemann, Stefan, 2011. "Dynamic monetary–fiscal interactions and the role of monetary conservatism," Journal of Monetary Economics, Elsevier, vol. 58(3), pages 234-247.
  11. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
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Cited by:
  1. Adam, Klaus, 2010. "Government Debt and Optimal Monetary and Fiscal Policy," CEPR Discussion Papers 8064, C.E.P.R. Discussion Papers.
  2. Stefan Niemann, 2009. "Dynamic Monetary-Fiscal Interactions and the Role of Monetary Conservatism," Economics Discussion Papers 667, University of Essex, Department of Economics.
  3. Niemann, Stefan & Pichler, Paul & Sorger, Gerhard, 2013. "Public debt, discretionary policy, and inflation persistence," Journal of Economic Dynamics and Control, Elsevier, vol. 37(6), pages 1097-1109.
  4. Niemann, Stefan & Pichler, Paul, 2011. "Optimal fiscal and monetary policies in the face of rare disasters," European Economic Review, Elsevier, vol. 55(1), pages 75-92, January.
  5. Adam, Klaus & Billi, Roberto M., 2006. "Monetary conservatism and fiscal policy," Working Paper Series 0663, European Central Bank.
  6. Dimakou, Ourania, 2013. "Monetary and fiscal institutional designs," Journal of Comparative Economics, Elsevier, vol. 41(4), pages 1141-1166.
  7. Klaus Adam, 2010. "Optimal Monetary and Fiscal Stabilisation Policies," OECD Economics Department Working Papers 765, OECD Publishing.
  8. Stefano Gnocchi, 2013. "Monetary Commitment and Fiscal Discretion: The Optimal Policy Mix," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(2), pages 187-216, April.

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