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When is Monetary Policy All we Need?

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  • Simon Wren-Lewis
  • Fabian Eser

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 true when allowing for inflation inertia through backward-looking rule-of-thumb price and wage-setting, as long as there in 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 University of Oxford, Department of Economics in its series Economics Series Working Papers with number 430.

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Date of creation: 01 May 2009
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Handle: RePEc:oxf:wpaper:430

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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. 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.
  2. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," CEPR Discussion Papers 2942, C.E.P.R. Discussion Papers.
  3. Pontiggia, Dario, 2007. "Inflation persistence and optimal positive long-run inflation," MPRA Paper 3274, University Library of Munich, Germany.
  4. 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.
  5. Leith, Campbell & Malley, Jim, 2005. "Estimated general equilibrium models for the evaluation of monetary policy in the US and Europe," European Economic Review, Elsevier, vol. 49(8), pages 2137-2159, November.
  6. Morten Ravn & Stephanie Schmitt-Grohé & Mart�n Uribe, 2006. "Deep Habits," Review of Economic Studies, Oxford University Press, vol. 73(1), pages 195-218.
  7. Tatiana Kirsanova & Simon Wren-Lewis, 2007. "Optimal fiscal feedback on debt in an economy with nominal rigidities," Working Paper 2007-26, Federal Reserve Bank of Atlanta.
  8. Tatiana Kirsanova & Mathan Satchi & David Vines & Simon Wren-Lewis, 2007. "Optimal Fiscal Policy Rules in a Monetary Union," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(7), pages 1759-1784, October.
  9. Campbell leith & Simon Wren-Lewis, . "Compatibility Between Monetary and Fiscal Policy Under EMU," Working Papers 2001_15, Business School - Economics, University of Glasgow.
  10. Gianluca Benigno & Bianca De Paoli, 2009. "On the International Dimension of Fiscal Policy," CEP Discussion Papers dp0905, Centre for Economic Performance, LSE.
  11. Jordi Galí & Tommaso Monacelli, 2005. "Optimal monetary and fiscal policy in a currency union," Economics Working Papers 909, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2008.
  12. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Series Working Papers 2009-W14, University of Oxford, Department of Economics.
  13. Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Optimal simple and implementable monetary and fiscal rules," Working Paper 2007-24, Federal Reserve Bank of Atlanta.
  14. Jordi Gali & Mark Gertler, 2000. "Inflation Dynamics: A Structural Econometric Analysis," NBER Working Papers 7551, National Bureau of Economic Research, Inc.
  15. Campbell Leith & Simon Wren-Lewis, 2006. "Fiscal Sustainability in a New Keynesian Model," Working Papers 2006_11, Business School - Economics, University of Glasgow, revised Nov 2008.
  16. 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.
  17. David Vines & Sven Jari Stehn, 2007. "Debt Stabilization Bias and the Taylor Principle," IMF Working Papers 07/206, International Monetary Fund.
  18. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  19. 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.
  20. Kevin D. Sheedy, 2007. "Robustly Optimal Monetary Policy," CEP Discussion Papers dp0840, Centre for Economic Performance, LSE.
  21. Jón Steinsson, 2000. "Optimal monetary policy in an economy with inflation persistence," Economics wp11, Department of Economics, Central bank of Iceland.
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Citations

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. Chen, Xiaoshan & Kirsanova, Tatiana & Leith, Campbell, 2013. "How Optimal is US Monetary Policy?," Stirling Economics Discussion Papers 2013-05, University of Stirling, Division of Economics.
  2. 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).
  3. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Papers 2009-W14, Economics Group, Nuffield College, University of Oxford.
  4. Eric M. Leeper, 2009. "Anchoring Fiscal Expectations," NBER Working Papers 15269, National Bureau of Economic Research, Inc.
  5. 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.
  6. Simon Wren-Lewis, 2011. "Comparing the delegation of monetary and fiscal policy," Economics Series Working Papers 540, University of Oxford, Department of Economics.
  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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