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Optimal Monetary Policy Response to Distortionary Tax Changes

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  • Michael Krause

    ()
    (Department of Economics Deutsche Bundesbank)

  • Wolfgang Lemke

    (Department of Economics Deutsche Bundesbank)

Abstract

We 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 Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 306.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:306

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Keywords: Nominal and real rigidities; distortionary taxation; optimal monetary policy;

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  1. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  2. Nessen, Marianne & Soderstrom, Ulf, 2001. "Core Inflation and Monetary Policy," International Finance, Wiley Blackwell, vol. 4(3), pages 401-39, Winter.
  3. Olivier Blanchard & Jordi Galí, 2005. "Real Wage Rigidities and the New Keynesian Model," Working Papers 243, Barcelona Graduate School of Economics.
  4. Sims, Christopher A, 2002. "Solving Linear Rational Expectations Models," Computational Economics, Society for Computational Economics, vol. 20(1-2), pages 1-20, October.
  5. Pierpaolo Benigno & Michael Woodford, 2004. "Inflation stabilization and welfare: The case of a distorted steady state," Discussion Papers 0405-04, Columbia University, Department of Economics.
  6. Jordi Gali, 2002. "New Perspectives on Monetary Policy, Inflation, and the Business Cycle," NBER Working Papers 8767, National Bureau of Economic Research, Inc.
  7. Robert E. Lucas, Jr. & N. Gregory Mankiw & Michael Woodford, 2005. "Panel discussion: understanding price determination: where are we now? where should we be going?," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  8. Rotemberg, Julio J, 1982. "Monopolistic Price Adjustment and Aggregate Output," Review of Economic Studies, Wiley Blackwell, vol. 49(4), pages 517-31, October.
  9. Walsh, Carl E., 2005. "Endogenous objectives and the evaluation of targeting rules for monetary policy," Journal of Monetary Economics, Elsevier, vol. 52(5), pages 889-911, July.
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Cited by:
  1. Sebastian Sienknecht, 2010. "On the Informational Loss Inherent in Approximation Procedures: Welfare Implications and Impulse Responses," Jena Economic Research Papers 2010-005, Friedrich-Schiller-University Jena, Max-Planck-Institute of Economics.

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