Optimal fiscal and monetary policy under different fiscal instruments

Purpose - The paper includes characterizing Ramsey policy in a cash-in-advance monetary model, under flexible and sticky prices, and with different fiscal instruments. Design/methodology/approach - The paper analytically and numerically characterizes the dynamic properties of Ramsey allocations. The author computes dynamics by solving second-order approximations to the Ramsey planner’s policy functions around a non-stochastic Ramsey steady state. Findings - The Friedman rule is not mainly optimal in a cash-in-advance model with distorting taxes. The Ramsey-optimal policy with both taxes on income and consumption calls for a high inflation rate that is extremely volatile, despite the fact that changing prices is costly. Practical implications - The optimality of zero nominal interest rate under flexible prices in monetary models is not mainly the case and quite depends on the preferences. The optimality of a zero inflation rate under sticky prices also very much depends on the assumed set of fiscal instruments. Originality/value - The non-optimality of the Friedman rule under flexible prices is quite new. Moreover, studying the optimal fiscal and monetary policy in a New Keynesian model with a rich set of fiscal instruments is also quite original.