Working Paper: NBER ID: w12402
Authors: Stephanie Schmitt-Grohé; Martín Uribe
Abstract: This paper computes welfare-maximizing monetary and fiscal policy rules in a real business cycle model augmented with sticky prices, a demand for money, taxation, and stochastic government consumption. We consider simple feedback rules whereby the nominal interest rate is set as a function of output and inflation, and taxes are set as a function of total government liabilities. We implement a second-order accurate solution to the model. Our main findings are: First, the size of the inflation coefficient in the interest-rate rule plays a minor role for welfare. It matters only insofar as it affects the determinacy of equilibrium. Second, optimal monetary policy features a muted response to output. More importantly, interest rate rules that feature a positive response to output can lead to significant welfare losses. Third, the welfare gains from interest-rate smoothing are negligible. Fourth, optimal fiscal policy is passive. Finally, the optimal monetary and fiscal rule combination attains virtually the same level of welfare as the Ramsey optimal policy.
Keywords: monetary policy; fiscal policy; welfare maximization; real business cycle
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 |
|---|---|
| size of the inflation coefficient in the interest rate rule (E31) | welfare (I38) |
| optimal monetary policy should feature a muted response to output (E63) | welfare (I38) |
| interest rate rules responding positively to output (E43) | significant welfare losses (D69) |
| welfare gains from interest rate smoothing (E43) | optimal fiscal policy is passive (E63) |
| optimal simple and implementable policy rule (E61) | nearly the same welfare level as the Ramsey optimal policy (H00) |