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Laffer traps and monetary policy

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  • Patrick A. Pintus

Abstract

This article focuses on the interaction, in a stylized economy with flexible prices, of monetary and fiscal policy when both are active-active in the sense that how the policy instrument is set depends on the state of the economy. Fiscal policy finances a given stream of government expenditures through distortionary labor taxes, and it operates under a strict balanced-budget rule. If monetary policy is passive, the economy may occasionally switch, because of self-fulfilling expectations, from the neighborhood of a "Laffer trap" equilibrium to the saddle-path leading to the high-welfare steady state. In the low-welfare stationary state, output, investment, and consumption are low while the tax rate is correspondingly high. However, active monetary policy may, by following a rule such that the nominal interest rate responds positively to the state of the economy, push the economy toward the high-welfare equilibrium and rule out expectation-driven business cycles.

Suggested Citation

  • Patrick A. Pintus, 2008. "Laffer traps and monetary policy," Review, Federal Reserve Bank of St. Louis, issue May, pages 165-174.
  • Handle: RePEc:fip:fedlrv:y:2008:i:may:p:165-174:n:v.90no.3,pt.1
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    Keywords

    Monetary policy ; Fiscal policy;

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