Working Paper: NBER ID: w11417
Authors: Stephanie Schmitt-Grohé; Martín Uribe
Abstract: In this paper, we study Ramsey-optimal fiscal and monetary policy in a medium-scale model of the U.S.\\ business cycle. The model features a rich array of real and nominal rigidities that have been identified in the recent empirical literature as salient in explaining observed aggregate fluctuations. The main result of the paper is that price stability appears to be a central goal of optimal monetary policy. The optimal rate of inflation under an income tax regime is half a percent per year with a volatility of 1.1 percent. This result is surprising given that the model features a number of frictions that in isolation would call for a volatile rate of inflation---particularly nonstate-contingent nominal public debt, no lump-sum taxes, and sticky wages. \nUnder an income-tax regime, the optimal income tax rate is quite stable, with a mean of 30 percent and a standard deviation of 1.1 percent. Simple monetary and fiscal rules are shown to implement a competitive equilibrium that mimics well the one induced by the Ramsey policy. When the fiscal authority is allowed to tax capital and labor income at different rates, optimal fiscal policy is characterized by a large and volatile subsidy on capital.
Keywords: Fiscal Policy; Monetary Policy; Macroeconomic Model
JEL Codes: E52; E61; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Optimal monetary policy (E63) | Price stability (E31) |
| Ramsey planner's preference for less distortion in taxing labor income (H21) | Low inflation volatility (E31) |
| Optimal income tax rate (H21) | Stability in income tax rate (H29) |
| Optimal fiscal policy (E62) | Large and volatile subsidy on capital (H29) |
| Nominal rigidities (D59) | Inflation volatility (E31) |
| Distortionary effects of taxation on labor and capital (H31) | Economic outcomes (F69) |
| Government purchases and transfers (H59) | Aggregate fluctuations (E10) |