Journal Article
Laffer traps and monetary policy
Abstract: This article focuses on the interaction, in a stylized economy with flexible prices, of monetary and fiscal policy when both are active-active in the sense that how the policy instrument is set depends on the state of the economy. Fiscal policy finances a given stream of government expenditures through distortionary labor taxes, and it operates under a strict balanced-budget rule. If monetary policy is passive, the economy may occasionally switch, because of self-fulfilling expectations, from the neighborhood of a \\"Laffer trap\\" equilibrium to the saddle-path leading to the high-welfare steady state. In the low-welfare stationary state, output, investment, and consumption are low while the tax rate is correspondingly high. However, active monetary policy may, by following a rule such that the nominal interest rate responds positively to the state of the economy, push the economy toward the high-welfare equilibrium and rule out expectation-driven business cycles.
Keywords: Monetary policy; Fiscal policy;
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Bibliographic Information
Provider: Federal Reserve Bank of St. Louis
Part of Series: Review
Publication Date: 2008
Volume: 90
Issue: May
Pages: 165-174