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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
Date of revision:
Handle: RePEc:oxf:wpaper:430
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  1. Jordi Gali & Tommaso Monacelli, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," NBER Working Papers 8905, National Bureau of Economic Research, Inc.
  2. Benigno, Gianluca & De Paoli, Bianca, 2009. "On the International Dimension of Fiscal Policy," CEPR Discussion Papers 7232, C.E.P.R. Discussion Papers.
  3. Tatiana Kirsanova & Simon Wren‐Lewis, 2012. "Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities," Economic Journal, Royal Economic Society, vol. 122(559), pages 238-264, 03.
  4. Kirsanova, Tatiana & Satchi, Mathan & Vines, David & Wren-Lewis, Simon, 2006. "Optimal Fiscal Policy Rules in a Monetary Union," CEPR Discussion Papers 5533, C.E.P.R. Discussion Papers.
  5. 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.
  6. 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.
  7. Jordi Galí & Tommaso Monacelli, 2015. "Optimal Monetary and Fiscal Policy in a Currency Union," Working Papers 240, Barcelona Graduate School of Economics.
  8. 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.
  9. Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
  10. 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.
  11. 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.
  12. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," CEPR Discussion Papers 2942, C.E.P.R. Discussion Papers.
  13. Ravn, Morten O & Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Deep Habits," CEPR Discussion Papers 4269, C.E.P.R. Discussion Papers.
  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.
  15. Fabian Eser, 2009. "Optimal Fiscal Stabilisation through Government Spending," Economics Series Working Papers 2009-W14, University of Oxford, Department of Economics.
  16. Kevin D. Sheedy, 2007. "Robustly optimal monetary policy," LSE Research Online Documents on Economics 3737, London School of Economics and Political Science, LSE Library.
  17. 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.
  18. Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Optimal simple and implementable monetary and fiscal rules," FRB Atlanta Working Paper No. 2007-24, Federal Reserve Bank of Atlanta.
  19. Jordi Gali & Mark Gertler, 2000. "Inflation Dynamics: A Structural Econometric Analysis," NBER Working Papers 7551, National Bureau of Economic Research, Inc.
  20. Steinsson, Jon, 2003. "Optimal monetary policy in an economy with inflation persistence," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1425-1456, October.
  21. Pontiggia, Dario, 2007. "Inflation persistence and optimal positive long-run inflation," MPRA Paper 3274, University Library of Munich, Germany.
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