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When is monetary policy all we need?

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  • Fabian Eser
  • Campbell Leith
  • Simon Wren-Lewis

Abstract

We consider optimal monetary and fiscal policies in a New Keynesian model of a small open economy with sticky prices and wages. In this benchmark setting monetary policy is all we need - analytical results demonstrate that variations in government spending should play no role in the stabilization of shocks. In extensions we show, firstly, that this is even when true when allowing for inflation inertia through backward-looking rule-of-thumb price and wage-setting, as long as there is no discrepancy between the private and social evaluation of the marginal rate of substitution between consumption and leisure. Secondly, the optimal neutrality of government spending is robust to the issuance of public debt. In the presence of debt government spending will deviate from the optimal steady-state but only to the extent required to cover the deficit, not to provide any additional macroeconomic stabilization. However, unlike government spending variations in tax rates can play a complementary role to monetary policy, as they change relative prices rather than demand.

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Bibliographic Info

Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2009_18.

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Date of creation: May 2009
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Handle: RePEc:gla:glaewp:2009_18

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Keywords: Monetary Policy; Fiscal Policy; Macroeconomic Stabilization; Dynamic General Equilibrium; Sticky Prices; Sticky wages; Rule-of-Thumb Behaviour; Debt; Countercyclical Policy;

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References

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  1. Jordi Galí & Mark Gertler, 1998. "Inflation dynamics: A structural econometric analysis," Economics Working Papers 341, Department of Economics and Business, Universitat Pompeu Fabra.
  2. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, vol. 116(512), pages F208-F231, 06.
  3. Ravn, Morten O. & Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Deep Habits," CEPR Discussion Papers 4269, C.E.P.R. Discussion Papers.
  4. Gali­, Jordi & Monacelli, Tommaso, 2008. "Optimal monetary and fiscal policy in a currency union," Journal of International Economics, Elsevier, vol. 76(1), pages 116-132, September.
  5. Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
  6. Tatiana Kirsanova & Simon Wren-Lewis, 2007. "Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities," Discussion Papers 0705, Exeter University, Department of Economics.
  7. Campbell leith & Simon Wren-Lewis, . "Compatibility Between Monetary and Fiscal Policy Under EMU," Working Papers 2001_15, Business School - Economics, University of Glasgow.
  8. Gianluca Benigno & Bianca De Paoli, 2009. "On the international dimension of fiscal policy," LSE Research Online Documents on Economics 28515, London School of Economics and Political Science, LSE Library.
  9. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Papers 2009-W14, Economics Group, Nuffield College, University of Oxford.
  10. Campbell Leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," CESifo Working Paper Series 699, CESifo Group Munich.
  11. Jordi Galí, 2007. "Constant interest rate projections without the curse of indeterminacy," Economics Working Papers 1057, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2008.
  12. Tatiana Kirsanova & David Vines & Mathan Satchi & Simon Wren-Lewis, 2005. "Optimal Fiscal Policy Rules in a Monetary Union," Money Macro and Finance (MMF) Research Group Conference 2005 40, Money Macro and Finance Research Group.
  13. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  14. Stehn, Sven Jari & Vines, David, 2008. "Strategic Interactions between an Independent Central Bank and a Myopic Government with Government Debt," CEPR Discussion Papers 6913, C.E.P.R. Discussion Papers.
  15. Pontiggia, Dario, 2007. "Inflation persistence and optimal positive long-run inflation," MPRA Paper 3274, University Library of Munich, Germany.
  16. Kevin D. Sheedy, 2007. "Robustly Optimal Monetary Policy," CEP Discussion Papers dp0840, Centre for Economic Performance, LSE.
  17. Steinsson, Jon, 2003. "Optimal monetary policy in an economy with inflation persistence," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1425-1456, October.
  18. Schmitt-Grohe, Stephanie & Uribe, Martin, 2007. "Optimal simple and implementable monetary and fiscal rules," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1702-1725, September.
  19. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," Departmental Working Papers 200105, Rutgers University, Department of Economics.
  20. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  21. David Vines & Sven Jari Stehn, 2007. "Debt Stabilization Bias and the Taylor Principle," IMF Working Papers 07/206, International Monetary Fund.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Is it a sin for the central bank to help reduce debt?
    by Mainly Macro in Mainly Macro on 2012-11-29 23:15:00
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Cited by:
  1. Leith, Campbell & Wren-Lewis, Simon, 2011. "Discretionary policy in a monetary union with sovereign debt," European Economic Review, Elsevier, vol. 55(1), pages 93-117, January.
  2. Eric M. Leeper, 2009. "Anchoring fiscal expectations," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 72, pages 17-42, September.
  3. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Series Working Papers 2009-W14, University of Oxford, Department of Economics.
  4. Kirsanova, Tatiana & Leith, Campbell & Chen, Xiaoshan, 2013. "How Optimal is US Monetary Policy?," SIRE Discussion Papers 2013-53, Scottish Institute for Research in Economics (SIRE).
  5. Simon Wren-Lewis, 2011. "Comparing the delegation of monetary and fiscal policy," Economics Series Working Papers 540, University of Oxford, Department of Economics.
  6. Leith, Campbell & Moldovan, Ioana & Rossi, Raffaele, 2009. "Monetary and Fiscal Policy under Deep Habits," SIRE Discussion Papers 2009-47, Scottish Institute for Research in Economics (SIRE).
  7. 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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