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Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach

In: NBER Macroeconomics Annual 2003, Volume 18

Listed author(s):
  • Pierpaolo Benigno
  • Michael Woodford

We propose an integrated treatment of the problems of optimal monetary and fiscal policy, for an economy in which prices are sticky and the only available sources of government revenue are distorting taxes. Our linear-quadratic approach allows us to nest both conventional analyses of optimal monetary stabilization policy and analyses of optimal tax-smoothing as special cases of our more general framework. We show how a linear-quadratic policy problem can be derived which yields a correct linear approximation to the optimal policy rules from the point of view of the maximization of expected discounted utility in a dynamic stochastic general-equilibrium model. Finally, we derive targeting rules through which the monetary and fiscal authorities may implement the optimal equilibrium. JEL Classification: E52, E61, E63

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This chapter was published in:
  • Mark Gertler & Kenneth Rogoff, 2004. "NBER Macroeconomics Annual 2003, Volume 18," NBER Books, National Bureau of Economic Research, Inc, number gert04-1.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 11445.
    Handle: RePEc:nbr:nberch:11445
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    2. Svensson, Lars E. O., 1998. "Inflation targeting as a monetary policy rule," CFS Working Paper Series 1998/16, Center for Financial Studies (CFS).
    3. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
    4. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
    5. Chari, V.V. & Kehoe, Patrick J., 1999. "Optimal fiscal and monetary policy," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 26, pages 1671-1745 Elsevier.
    6. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2000. "Optimal monetary policy," Working Paper 00-10, Federal Reserve Bank of Richmond.
    7. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    8. Isabel Correia & Juan Pablo Nicolini & Pedro Teles, 2008. "Optimal fiscal and monetary policy: equivalence results," Staff Report 403, Federal Reserve Bank of Minneapolis.
    9. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc.
    10. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
    11. Martin Uribe & Stephanie Schmitt-Grohe, 2001. "Optimal fiscal and monetary policy under sticky prices," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
    12. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Inflation Targeting Rules," NBER Working Papers 9939, National Bureau of Economic Research, Inc.
    13. Sbordone, A.M., 1998. "Prices and Unit Labor Costs: a New Test of Price Stickiness," Papers 653, Stockholm - International Economic Studies.
    14. Lars E. O. Svensson & Michael Woodford, 2003. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Working Papers 9747, National Bureau of Economic Research, Inc.
    15. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
    16. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
    17. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
    18. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
    19. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
    20. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
    21. Bernheim, B Douglas, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 540-542, August.
    22. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, pages 519-546.
    23. George J. Hall & Stefan Krieger, 2000. "Tax Smoothing Implications of the Federal Debt Paydown," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 31(2), pages 253-302.
    24. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-971, October.
    25. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal Fiscal Policy in a Business Cycle Model," NBER Working Papers 4490, National Bureau of Economic Research, Inc.
    26. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-1230, December.
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