Equilibria Under Monetary and Fiscal Policy Interactions in a Portfolio Choice Model

This paper analyzes the aftermath of monetary and fiscal policy interactions from the perspective of portfolio choice. In particular, it studies how the presence of income- taxes change the properties of general equilibrium models. It finds that relative to the previous literature [following Leeper (1991)] a new regime exists where a passive fiscal rule combined with a passive monetary rule can still deliver determinacy where the same area of the parameter space would lead to multiple solutions if taxes were lump sum. It characterizes analytically the extent to which tax cuts are self-financing and how the distortionary tax Laffer curve looks near the steady state in order to obtain the size of the new regime. In the new regime, the inflation target can temporarily increase in order to increase seigniorage revenues. With this flexibility, the monetary policy is consistent with the real debt remaining bounded, and the arithmetic that follows is monetarist and unpleasant in the sense of Sargent and Wallace (1981).