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When is Monetary Policy All we Need?

  • 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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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
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Handle: RePEc:oxf:wpaper:430
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  10. Campbell Leith & Simon Wren-lewis, 2006. "Fiscal Sustainability in a New Keynesian Model," WEF Working Papers 0006, ESRC World Economy and Finance Research Programme, Birkbeck, University of London.
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  13. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," Departmental Working Papers 200105, Rutgers University, Department of Economics.
  14. 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.
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  16. Leith, Campbell & Simon Wren-Lewis, 2002. "Compatibility Between Monetary and Fiscal Policy Under EMU," Royal Economic Society Annual Conference 2002 124, Royal Economic Society.
  17. Jón Steinsson, 2000. "Optimal monetary policy in an economy with inflation persistence," Economics wp11, Department of Economics, Central bank of Iceland.
  18. 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.
  19. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Series Working Papers 2009-W14, University of Oxford, Department of Economics.
  20. Jordi Galí & 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.
  21. Pontiggia, Dario, 2007. "Inflation persistence and optimal positive long-run inflation," MPRA Paper 3274, University Library of Munich, Germany.
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