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Optimal Inflation Targeting Under Alternative Fiscal Regimes

  • Pierpaolo Benigno
  • Michael Woodford

Flexible inflation targeting has been advocated as a practical approach to the implementation of an optimal state-contingent monetary policy, but theoretical expositions reaching this conclusion have typically abstracted from the fiscal consequences of monetary policy. Here we extend the standard theory by considering the character of optimal monetary policy under a variety of assumptions about the fiscal regime, with the standard analysis appearing only as a special case in which non-distorting sources of government revenue exist, and fiscal policy can be relied upon to adjust so as to ensure intertemporal government solvency. Alternative cases treated in this paper include ones in which there exist only distorting sources of government revenue; and also ones in which fiscal policy is purely exogenous, so that the central bank cannot rely upon fiscal policy to adjust in order to maintain intertemporal solvency (a case emphasized in the critique of inflation targeting by Sims, 2005). We find that the fiscal policy regime has important consequences for the optimal conduct of monetary policy, but that a suitably modified form of inflation targeting will still represent a useful approach to the implementation of optimal policy. We derive an optimal targeting rule for monetary policy that applies to all of the fiscal regimes considered in this paper, and show that it involves commitment to an explicit target for an output-gap adjusted price level. The optimal policy will allow temporary departures from the long-run target rate of growth in the gap-adjusted price level in response to disturbances that affect the government’s budget, but it will also involve a commitment to rapidly restore the projected growth rate of this variable to its normal level following such disturbances, so that medium-term inflation expectations should remain firmly anchored despite the occurrence of fiscal shocks.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 407.

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Date of creation: Dec 2006
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Handle: RePEc:chb:bcchwp:407
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  1. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
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  4. Svensson, Lars & Woodford, Michael, 2000. "Indicator Variables for Optimal Policy," Seminar Papers 688, Stockholm University, Institute for International Economic Studies.
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  9. Sims, Christopher A, 2001. "Fiscal Consequences for Mexico of Adopting the Dollar," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 597-616, May.
  10. Pierpaolo Benigno & Michael Woodford, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," NBER Working Papers 10838, National Bureau of Economic Research, Inc.
  11. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
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  13. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: II. Applications," NBER Working Papers 9420, National Bureau of Economic Research, Inc.
  14. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
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  18. King, Mervyn, 1997. "Changes in UK monetary policy: Rules and discretion in practice," Journal of Monetary Economics, Elsevier, vol. 39(1), pages 81-97, June.
  19. George-Marios Angeletos, 2002. "Fiscal Policy With Noncontingent Debt And The Optimal Maturity Structure," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 1105-1131, August.
  20. Levin, Andrew T. & Natalucci, Fabio M. & Piger, Jeremy M., 2004. "Explicit inflation objectives and macroeconomic outcomes," Working Paper Series 0383, European Central Bank.
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