Optimal Fiscal and Monetary Policy In A Medium Scale Macro Model

In this paper we study optimal fiscal and monetary rules in a medium-scale estimated model of the U.S. business cycle. The model features several real and nominal rigidities that have been identfied in the recent literature as salient in explaining observed aggregate fluctuations. The government is assumed to conduct stabilization policy through the use of fiscal and monetary policy instruments. The fiscal instruments are capital and labor income tax rates, the monetary instrument is the nominal interest rate. The paper first characterizes Ramsey steady states. (Contrary to earlier papers that study optimal capital income taxation in models with imperfect competition, we find that the optimal capital income subsidy is not just equal to the markup but about 4 times larger. The reason for this discrepancy is that earlier papers abstracted from depreciation and the tax deductability of depreciation.) The paper characterizes the dynamic behavior of the economy under the Ramsey equilibrium. These dynamics are then used to find simple fiscal and monetary rules that imply dynamics similar to those induced by the Ramsey equilibrium. Specifically, the parameters of the monetary and fiscal rules are chosen so as to minimize the difference between the impulse responses of key macro aggregates under the Ramsey rule and under simple parametrized monetary and fiscal policy rules. In practise, an important difference between the monetary policy instrument and the fiscal policy instruments is that the nominal interest rate can be adjusted almost instantaneously if needed, whereas tax rates are much less flexible and typically are determined many periods in advance. We model this difference between fiscal and monetary policy instruments by assuming that it takes time to tax. We then ask whether the time-to-tax feature of fiscal policy reduces the power of fiscal instruments to stabilize the economy. The paper also makes some methodological contributions. It shows how to characterize Ramsey equilibria of medium-scale macro models by means of symbolic algebra tools.