Working Paper

Optimal fiscal and monetary policy with sticky wages and sticky prices

Abstract: We determine the optimal degree of price inflation volatility when nominal wages are sticky and the government uses state-contingent inflation to finance government spending. We address this question in a well-understood Ramsey model of fiscal and monetary policy, in which the benevolent planner has access to labor income taxes, nominal riskless debt, and money creation. One main result is that sticky wages alone make price stability optimal in the face of government spending shocks, to a degree quantitatively similar as sticky prices alone. With productivity shocks also present, optimal inflation volatility is higher, but still dampened relative to the fully-flexible economy. Key for our results is an equilibrium restriction between nominal price inflation and nominal wage inflation that holds trivially in a Ramsey model featuring only sticky prices. We also show that the nominal interest rate can be used to indirectly tax the rents of monopolistic labor suppliers. Interestingly, a necessary condition for the ability to use the nominal interest rate for this purpose is positive producer profits. Taken together, our results uncover features of Ramsey fiscal and monetary policy in the presence of labor market imperfections that are widely-believed to be important.

Keywords: Inflation (Finance) - Mathematical models; Monetary policy - Mathematical models; Fiscal policy - Mathematical models;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2005

Number: 834