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When is Monetary Policy All we Need?

Listed author(s):
  • Simon Wren-Lewis
  • Fabian Eser

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 true when allowing for inflation inertia through backward-looking rule-of-thumb price and wage-setting, as long as there in 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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File URL: http://www.economics.ox.ac.uk/materials/working_papers/paper430.pdf
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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 430.

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Date of creation: 01 May 2009
Handle: RePEc:oxf:wpaper:430
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Web page: http://www.economics.ox.ac.uk/
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  1. Campbell Leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," CESifo Working Paper Series 699, CESifo Group Munich.
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  12. Campbell Leith & Simon Wren-Lewis, 2006. "Fiscal Sustainability in a New Keynesian Model," Working Papers 2006_11, Business School - Economics, University of Glasgow, revised Nov 2008.
  13. Galí, Jordi & Gertler, Mark, 1999. "Inflation Dynamics: A Structural Economic Analysis," CEPR Discussion Papers 2246, C.E.P.R. Discussion Papers.
  14. 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.
  15. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," Departmental Working Papers 200105, Rutgers University, Department of Economics.
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  17. Jón Steinsson, 2000. "Optimal monetary policy in an economy with inflation persistence," Economics wp11, Department of Economics, Central bank of Iceland.
  18. Pontiggia, Dario, 2007. "Inflation persistence and optimal positive long-run inflation," MPRA Paper 3274, University Library of Munich, Germany.
  19. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  20. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, September.
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  24. Svan Jari Stehn & David Vines, 2007. "Debt Stabilisation Bias And The Taylor Principle: Optimal Policy In A New Keynesian Model With Government Debt And Inflation Persistence," CAMA Working Papers 2007-22, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
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  26. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Papers 2009-W14, Economics Group, Nuffield College, University of Oxford.
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