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Title: Optimal Simple and Implementable Monetary and Fiscal Rules

Author(s): Stephanie Schmitt-Groh� and Mart�n Uribe

Publication Date: March 2004

Keyword(s): nominal rigidities, optimal fiscal and monetary policy, optimal inflation volatility and second-order approximation techniques

Programme Area(s): International Macroeconomics

Abstract: The goal of this Paper is to compute optimal 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 policy 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 require policy to be implementable in the sense that it guarantees uniqueness of equilibrium. We do away with a number of empirically unrealistic assumptions typically maintained in the related literature that are used to justify the computation of welfare using linear methods. Instead, 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 of the nominal interest rate to output can lead to significant welfare losses. Third, the optimal fiscal policy is passive. The welfare losses associated with the adoption of an active fiscal stance are, however, negligible.

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Bibliographic Reference

Schmitt-Groh�, S and Uribe, M. 2004. 'Optimal Simple and Implementable Monetary and Fiscal Rules'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4334