Working Paper: CEPR ID: DP220
Authors: George Alogoskoufis
Abstract: This paper considers optimal stabilization policy and nominal income targets for an open economy where the authorities are concerned both with unemployment and monetary instability. To fully achieve these two objectives the authorities must use both monetary and "supply-side" fiscal policy. It is shown that there is an optimal assignment of monetary policy to the monetary stability objective, and supply-side fiscal policy to the unemployment objective. In a second-best world, where only monetary policy can be used in the short run, there is an optimal exchange rate rule, which balances the welfare cost of unemployment against that of monetary instability. This rule prescribes appreciations of the exchange rate following domestic supply shocks and external price and interest rate shocks. Domestic money demand shocks do not, however, necessitate a change in the exchange rate. The analysis suggests that nominal income targets are an optimal policy only if supply and world interest rate shocks do not occur. Alternatively, they are optimal if monetary stability carries no weight in the policy-makers' objective function and fiscal policy can be directed against supply shocks.
Keywords: stabilization policy; nominal income targets; open economies
JEL Codes: 300; 431
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal stabilization policies (E63) | monetary stability (E63) |
| optimal stabilization policies (E63) | full employment (J68) |
| monetary policy assignment (E52) | monetary stability (E63) |
| fiscal policy assignment (E62) | unemployment (J64) |
| nominal income targets (E64) | welfare losses (D69) |
| supply shocks (E39) | nominal income targets (E64) |
| monetary stability prioritization (E63) | nominal income targets (E64) |
| fiscal policy (E62) | supply shocks (E39) |
| exchange rate rule (F31) | welfare costs of unemployment (J65) |
| exchange rate rule (F31) | monetary instability (E49) |
| domestic money demand shocks (E41) | exchange rate (F31) |
| nominal income targets (E64) | labor market equilibrium (J20) |