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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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  1. Gali­, Jordi & Monacelli, Tommaso, 2008. "Optimal monetary and fiscal policy in a currency union," Journal of International Economics, Elsevier, vol. 76(1), pages 116-132, September.
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  3. Jón Steinsson, 2000. "Optimal monetary policy in an economy with inflation persistence," Economics wp11, Department of Economics, Central bank of Iceland.
  4. 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.
  5. Stehn, Sven Jari & Vines, David, 2008. "Strategic Interactions between an Independent Central Bank and a Myopic Government with Government Debt," CEPR Discussion Papers 6913, C.E.P.R. Discussion Papers.
  6. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Papers 2009-W14, Economics Group, Nuffield College, University of Oxford.
  7. Leith, Campbell & Simon Wren-Lewis, 2002. "Compatibility Between Monetary and Fiscal Policy Under EMU," Royal Economic Society Annual Conference 2002 124, Royal Economic Society.
  8. 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.
  9. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," CEPR Discussion Papers 2942, C.E.P.R. Discussion Papers.
  10. Leith, Campbell & Malley, Jim, 2005. "Estimated general equilibrium models for the evaluation of monetary policy in the US and Europe," European Economic Review, Elsevier, vol. 49(8), pages 2137-2159, November.
  11. 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.
  12. Gali, Jordi & Gertler, Mark, 1999. "Inflation dynamics: A structural econometric analysis," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 195-222, October.
  13. Pontiggia, Dario, 2007. "Inflation persistence and optimal positive long-run inflation," MPRA Paper 3274, University Library of Munich, Germany.
  14. Tatiana Kirsanova & Mathan Satchi & David Vines & Simon Wren-Lewis, 2007. "Optimal Fiscal Policy Rules in a Monetary Union," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(7), pages 1759-1784, October.
  15. Gianluca Benigno & Bianca De Paoli, 2009. "On the International Dimension of Fiscal Policy," CEP Discussion Papers dp0905, Centre for Economic Performance, LSE.
  16. Morten Ravn & Stephanie Schmitt-Grohé & Mart�n Uribe, 2006. "Deep Habits," Review of Economic Studies, Oxford University Press, vol. 73(1), pages 195-218.
  17. Kevin D. Sheedy, 2007. "Robustly Optimal Monetary Policy," CEP Discussion Papers dp0840, Centre for Economic Performance, LSE.
  18. 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.
  19. Jordi Galí & Tommaso Monacelli, 2003. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Working Papers 11, Barcelona Graduate School of Economics.
  20. 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.
  21. 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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