Optimal Monetary Policy Response to Distortionary Tax Changes
AbstractWe analyze the trade-offs faced by a monetary policy authority when a value added tax rate is increased. In the short run, such an increase acts as a cost push shock from the perspective of a central bank that is concerned with stabilizing the welfare relevant output gap. We develop a New Keynesian monetary model with real wage rigidity and consider the effects that obtain under a simple interest rate rule, on the one hand, and those that obtain under an optimal monetary policy from a timeless perspective (in the terminology of Woodford, 2003). The implications for the dynamic response of the economy differ in the presence of real wage rigidity. While under a rule inflation is higher for about eight quarters, the optimal policy involves an adjustment that is about half as long, and is followed by a slight deflation. The reason is that this policy can be shown to include a commitment to target a certain price-level, which helps contain inflation expectations. We treat the tax shock as permanent, so that the central bank does not fully revert the price level to its orginal level.
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Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 306.
Date of creation: 04 Jul 2006
Date of revision:
Nominal and real rigidities; distortionary taxation; optimal monetary policy;
Find related papers by JEL classification:
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-07-15 (All new papers)
- NEP-CBA-2006-07-21 (Central Banking)
- NEP-MAC-2006-07-18 (Macroeconomics)
- NEP-MON-2006-07-15 (Monetary Economics)
- NEP-PBE-2006-07-18 (Public Economics)
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