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When is monetary policy all we need?

  • Fabian Eser
  • Campbell Leith
  • Simon Wren-Lewis

We consider optimal monetary and fiscal policies in a New Keynesian model of a small open economy with sticky prices and wages. In this benchmark setting monetary policy is all we need - analytical results demonstrate that variations in government spending should play no role in the stabilization of shocks. In extensions we show, firstly, that this is even when true when allowing for inflation inertia through backward-looking rule-of-thumb price and wage-setting, as long as there is no discrepancy between the private and social evaluation of the marginal rate of substitution between consumption and leisure. Secondly, the optimal neutrality of government spending is robust to the issuance of public debt. In the presence of debt government spending will deviate from the optimal steady-state but only to the extent required to cover the deficit, not to provide any additional macroeconomic stabilization. However, unlike government spending variations in tax rates can play a complementary role to monetary policy, as they change relative prices rather than demand.

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2009_18.

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Date of creation: May 2009
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Handle: RePEc:gla:glaewp:2009_18
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  1. Tatiana Kirsanova & Mathan Satchi & David Vines & Simon Wren-Lewis, 2006. "Optimal Fiscal Policy Rules in a Monetary Union," Discussion Papers 0611, Exeter University, Department of Economics.
  2. Tatiana Kirsanova & Simon Wren-Lewis, 2007. "Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities," Discussion Papers 0705, Exeter University, Department of Economics.
  3. Jón Steinsson, 2000. "Optimal monetary policy in an economy with inflation persistence," Economics wp11, Department of Economics, Central bank of Iceland.
  4. David Vines & Sven Jari Stehn, 2007. "Debt Stabilization Bias and the Taylor Principle; Optimal Policy in a New Keynesian Model with Government Debt and Inflation Persistence," IMF Working Papers 07/206, International Monetary Fund.
  5. Jordi Gali & Mark Gertler, 2000. "Inflation Dynamics: A Structural Econometric Analysis," NBER Working Papers 7551, National Bureau of Economic Research, Inc.
  6. Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Optimal simple and implementable monetary and fiscal rules," Working Paper 2007-24, Federal Reserve Bank of Atlanta.
  7. Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
  8. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Papers 2009-W14, Economics Group, Nuffield College, University of Oxford.
  9. Gianluca Benigno & Bianca De Paoli, 2009. "On the International Dimension of Fiscal Policy," CEP Discussion Papers dp0905, Centre for Economic Performance, LSE.
  10. Pontiggia, Dario, 2007. "Inflation persistence and optimal positive long-run inflation," MPRA Paper 3274, University Library of Munich, Germany.
  11. Sven Jari Stehn & David Vines, 2008. "Strategic Interactions Between An Independent Central Bank and a Myopic Government with Government Debt," IMF Working Papers 08/164, International Monetary Fund.
  12. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  13. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  14. Tommaso Monacelli & Jordi Galí, 2005. "Optimal Monetary and Fiscal Policy in a Currency Union," Working Papers 300, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  15. Morten O. Ravn & Stephanie Schmitt-Grohe, 2004. "Deep Habits," 2004 Meeting Papers 208, Society for Economic Dynamics.
  16. Leith, Campbell & Wren-Lewis, Simon, 2006. "Compatibility between monetary and fiscal policy under EMU," European Economic Review, Elsevier, vol. 50(6), pages 1529-1556, August.
  17. Campbell leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," Working Papers 2001_16, Business School - Economics, University of Glasgow.
  18. Kevin D. Sheedy, 2007. "Robustly optimal monetary policy," LSE Research Online Documents on Economics 3737, London School of Economics and Political Science, LSE Library.
  19. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, vol. 116(512), pages F208-F231, 06.
  20. Martin Uribe & Stephanie Schmitt-Grohe, 2001. "Optimal fiscal and monetary policy under sticky prices," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  21. Jordi Galí, 2007. "Constant interest rate projections without the curse of indeterminacy," Economics Working Papers 1057, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2008.
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