Distortionary fiscal policy and monetary policy goals
Abstract: We study interactions between monetary policy, which sets nominal interest rates, and fiscal policy, which levies distortionary income taxes to finance public goods, in a standard, sticky-price economy with monopolistic competition. Policymakers? inability to commit in advance to future policies gives rise to excessive inflation and excessive public spending, resulting in welfare losses equivalent to several percent of consumption each period. We show how appointing a conservative monetary authority, which dislikes inflation more than society does, can considerably reduce these welfare losses and that optimally the monetary authority is predominantly concerned about inflation. Full conservatism, i.e., exclusive concern about inflation, entirely eliminates the welfare losses from discretionary monetary and fiscal policymaking, provided monetary policy is determined after fiscal policy each period. Full conservatism, however, is severely suboptimal when monetary policy is determined simultaneously with fiscal policy or before fiscal policy each period.
File(s): File format is application/pdf http://www.kansascityfed.org/PUBLICAT/RESWKPAP/PDF/RWP10-10.pdf
Provider: Federal Reserve Bank of Kansas City
Part of Series: Research Working Paper
Publication Date: 2010
Number: RWP 10-10