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Monetary Policy, Taxes, and the Business Cycle

  • Michael R. Pakko
  • William T. Gavin

    ()

    (Research Federal Reserve Bank of St. Louis)

  • Finn E. Kydland

This paper analyzes the interaction of inflation with the tax code and its contribution to aggregate fluctuations. We find significant effects operating through the tax on realized nominal capital gains. A tax on nominal bond income magnifies these effects. Our innovation is to combine monetary policy shocks with non-indexed taxes in a model where the central bank implements policy using an interest rate rule. Monetary policy had important effects on the behavior of the business cycle before 1980 because policymakers did not exert effective control over inflation. Monetary policy reform around 1980 led to better control, and with more stable inflation, the effect of the interaction between monetary policy and the nominal capital gains tax has become negligible.

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Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 265.

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Date of creation: 2005
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Handle: RePEc:red:sed005:265
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