Optimal fiscal policy and the Fiscal Theory of the Price Level

This paper studies optimal fiscal policy in the context of a DSGE model in which the optimizing government can issue nominal non-contingent debt and is subject to an independent monetary policy setting the nominal interest rate according to an inflation targeting rule. The fiscal authority can stabilize the economy having several tools at its disposal, including government consumption, public investment and distortionary taxes. We focus on the case where the monetary authority sets the nominal interest rate to respond weakly to inflation, the so called passive money regime Leeper (1991). We compare the outcome of optimal fiscal policy in that case with the polar opposite, when the monetary authority aggressively responds to inflation. It is well known that in standard DGSE models (without an optimizing government and when fiscal policy follows ad hoc rules) switching from an active to a passive monetary regime, brings about a considerable increase in macroeconomic volatility, mainly due to inflation fluctuations reflect debt sustainability. We ask whether optimal fiscal policy would choose to set fiscal variables irresponsibly when inflation fiscal debt in the passive money case. We find that the answer is no. The differences in the optimal policy allocation under active/passive monetary policies are small when the fundamental disturbances that hit the economy are standard demand shocks. We show that this result holds both under full commitment and in the case where time-consistent policy cannot commit to the future path of its fiscal variables. In both cases changing the monetary regime from active to passive only has a small effect on equilibrium outcomes.