Working Paper

Targeting inflation and the fiscal balance : what is the optimal policy mix?

Abstract: This paper identifies optimal policy rules in the presence of explicit targets for both the inflation rate and public debt. This issue is investigated in the context of a dynamic stochastic general equilibrium model that describes a small open economy with capital accumulation, distortionary taxation and nominal price rigidities. The model is solved using a second-order approximation to the equilibrium conditions. Optimal policy features a strong anti-inflation stance and strict fiscal discipline. Targeting a domestic inflation index - as opposed to CPI - improves welfare because it reduces the inefficiencies that stem from both price stickiness and income taxes.

Keywords: Inflation (Finance); Prices; Fiscal policy;

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2006

Number: RWP 06-07