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Monetary policy, taxes and the business cycle

  • William T. Gavin
  • Finn E. Kydland
  • Michael R. Pakko

This paper analyzes the interaction of inflation with the tax code and its contribution to aggregate fluctuations. We find significant effects operating through the tax on realized nominal capital gains. A tax on nominal bond income magnifies these effects. Our innovation is to combine monetary policy shocks with non-indexed taxes in a model where the central bank implements policy using an interest rate rule. Monetary policy had important effects on the behavior of the business cycle before 1980 because policymakers did not exert effective control over inflation. Monetary policy reform around 1980 led to better control, and with more stable inflation, the effect of the interaction between monetary policy and the nominal capital gains tax has become negligible.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2004-017.

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Date of creation: 2006
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Handle: RePEc:fip:fedlwp:2004-017
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