Top PDF Monetary commitment and fiscal discretion : the optimal policy mix

Monetary commitment and fiscal discretion : the optimal policy mix

Monetary commitment and fiscal discretion : the optimal policy mix

inflation and the output gap. Hence, because of the concavity of the welfare func- tion, it is optimal to temporarily accept both some positive inflation and a negative output gap. In addition, in the case of commitment and perfect coordination, the fiscal stance remains neutral. In fact, the government expenditure gap is closed and the fiscal gap fluctuates one-to-one with the output gap. Instead, under fiscal dis- cretion the government expenditure gap responds to wage mark-up shocks. This fact worsens the trade-off between inflation and output gap stabilization faced by the central bank. A committed central bank could still eliminate fiscal overreac- tion completely by behaving as a discretionary monetary authority. Though feasible, this policy would be sub-optimal, therefore a combination of positive inflation, out- put gap and fiscal gap variability is preferred. In fact, the monetary authority gives up the active use of the expectation channel to some extent so as to contain fiscal misbehavior. Equilibrium fluctuations represent the maximum deviation from full commitment that the monetary authority is willing to accept so as to reduce public spending variability. Finally, although the fiscal rule targets contemporaneous vari- ables, monetary policy induces inertia by suitably choosing her policy instrument. This is evident from Figure 1. Since the cost-push shock is serially uncorrelated, inertia must be entirely generated by monetary policy. This is a well-established
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Optimal Monetary Policy, Commitment, and Imperfect Credibility

Optimal Monetary Policy, Commitment, and Imperfect Credibility

Finite regime duration is of particular interest from a practical point of view, since no central bank–even under perfect credibility–can commit for infinite number of periods, due to presence of unavoidable factors such as reappointment of the central bank administration, “large” shocks, institutional changes, etc.... Hence, even if the individual policy maker has perfect credibility of intentions, it is possible to talk about an imperfection in the commitment process due to frictions just mentioned. To incorporate this issue into the optimal monetary policy framework, we have constructed a setup in which the central bank can reformulate the policy with an average frequency that is known to the private agents. In other words, the private agents truly contemplate policy intentions. This setup allowed us to obtain a unique rational expectations equilibrium, without dealing with reputational problems. Consequently, we have characterized the equilibrium under a continuum where full commitment and discretion corresponds to two edges of the spectrum. Most of the gains from commitment is accrued under low degrees of commitment, confirming the central banks’ concern about achieving a stable level of credibility. In other words, as long as the monetary authority’s policy intentions match to the private expectations, even a commitment lasting a couple of quarters is enough to cover most of the gains from commitment.
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Targeting inflation and the fiscal balance : what is the optimal policy mix?

Targeting inflation and the fiscal balance : what is the optimal policy mix?

the welfare loss associated to a …scal rule that features a sluggish response of the primary surplus to deviations of public debt with respect to the liabilities target. Welfare implications are reported in line (B) in Table (3). The monetary policy rule parameters remain the same = 2:15; y = 0:55 but now 1 = 0:05 is imposed. The volatility of public debt becomes signi…cantly higher, but the welfare loss is small (compared to the case of optimal CPI targeting with fast …scal adjustment). One of the reasons is that the policy that prescribes a slow …scal adjustment delivers a very similar level of tax rate volatility. The intuition is that, as the adjustment gets postponed, the size of the …scal imbalance gets larger, hence higher tax rate adjustments are required in the future.
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Optimal Fiscal Policy in a Monetary Union

Optimal Fiscal Policy in a Monetary Union

“minor nuisance”. Beetsma and Debrun (2004, 2005) argue that fiscal limits ´a la SGP help reduce the deficit bias of electorally-motivated governments but also reduce spending on “high-quality” outlays such as public investment and other outlays typically associated with economic reforms. Wyplosz (2005, 2006) argue that the SGP is flawed, even though it has influenced policymakers in the sense that fiscal policy would have likely been less disciplined than they have been. Nevertheless, fiscal policy should follow the lead from monetary policy and move from discretion to rules and then to institutions. This logical sequence has been put into practice for monetary policy and it has worked remarkably well. We contribute to this literature by providing a formal assessment of how often the SGP would bind if fiscal policy were optimal.
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Limited Commitment, Inaction and Optimal Monetary Policy

Limited Commitment, Inaction and Optimal Monetary Policy

is preferred to pure discretion for most plausible parameter values. The intuition behind this finding is straightforward. A discretionary policy allows a timely response to exogenous disturbances, but features higher output costs of reducing inflation. On the other hand, under infrequent adjustment, the central bank acts as if under commitment every second period, but leaves some shocks in non-meeting months unanswered. While the latter con- tributes to the volatility of target variables, the effects of commitment are the opposite. In particular, commitment reduces the cost disinflation at the time of adjustment and prompts a more aggressive response to inflationary pressures. Quick disinflations make the effects of exogenous shocks on inflation die out faster under periodic adjustment than they do under period-by-period adjustment. This effect contains inflationary expectations and inflation it- self in non-meeting months, producing lower volatility of inflation in all periods. We find that for many plausible parameter values these benefits from commitment dominate the destabi- lizing effects of inaction. Section 4 discusses the optimal frequency of policy meetings, its determinants and the application of our analysis to the U.S. case. Section 5 concludes.
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Discretionary Fiscal Policy and Optimal Monetary Policy in a Currency Area

Discretionary Fiscal Policy and Optimal Monetary Policy in a Currency Area

The paper evaluates the effects of fiscal discretion in a currency area, where a common and independent monetary authority commits to optimally set the union-wide nominal interest rate. National governments implement fiscal pol- icy by choosing government expenditure. The assumption of fiscal policy coor- dination across countries is retained in order to evaluate the costs exclusively due to discretion, leaving aside the free-riding problems stemming from non- cooperation. In such a context, nominal rigidities potentially generate a stabi- lization role for fiscal policy, in addition to the one of ensuring efficient provision of public goods. However, it is showed that, under discretion, aggregate fiscal policy stance is inefficiently loose and the volatility of government expenditure is higher than optimal. As an implication, the optimal monetary policy rule involves the targeting of union-wide fiscal stance, on top of inflation and output gap. The result questions the welfare enhancing role of government expenditure, as the proper instrument for stabilizing asymmetric shocks. In fact, discretion entails significant welfare costs, the magnitude depending on the stochastic prop- erties of the shocks and, for plausible parameter values, it is not optimal to use fiscal policy as a stabilization tool.
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The Maastricht Criteria and Optimal Monetary and Fiscal Policy Mix for the EMU Accession Countries

The Maastricht Criteria and Optimal Monetary and Fiscal Policy Mix for the EMU Accession Countries

In this framework we characterize the optimal monetary and …scal policy from a timeless perspective (Wood- ford (2003)). As in Lipi´nska (2008), we derive the micro founded loss function using the second order approx- imation methodology developed by Rotemberg and Woodford (1997) and Benigno and Woodford (2005). We …nd that the optimal monetary and …scal policy (unconstrained policy) should not only target in‡ation rates in the domestic sectors and aggregate output ‡uctuations but also domestic and international terms of trade. Subsequently, we present how the loss function changes when the monetary and …scal policy is constrained by the Maastricht convergence criteria. We derive the optimal monetary and …scal policy that satis…es all the Maastricht convergence criteria (constrained policy). Importantly, the Maastricht convergence criteria are not easily implementable in our model. Here we take an advantage of the methodology developed by Rotemberg and Woodford (1997, 1999) for the analysis of the zero bound problem and adapted by Lipi´nska (2008) for the analysis of the monetary criteria. This method enables us to verify whether a given criterion is satis…ed by only computing …rst and second moments of a variable for which the criterion is set.
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A welfare perspective on the fiscal-monetary policy mix: The role of alternative fiscal instruments

A welfare perspective on the fiscal-monetary policy mix: The role of alternative fiscal instruments

Table 8 is particularly important, as it reports the unconditional welfare measures - again for each fiscal instrument - associated with different a different degree of distortions in the model economy. Two results are noteworthy, one ‘horizontal’ and the other ‘vertical’ in terms of visualization of the table. The ‘horizontal’ result is that, ceteris paribus, the distortions arising from the presence of monopolistic competition and, although to a lesser extent, from the presence of money are the most relevant. Moving from price flexibility to price rigidity (within a monopolistic competition framework), on the other hand, does not deliver per se any additional welfare losses. On the other hand, a ‘vertical’ reading of Table 8 delivers a fairly homogenous welfare ranking: focusing on distortionary taxation, in cashless economies productive government spending targeting yields the lowest welfare loss, followed by consumption taxation and then by government consumption targeting. In monetary economies, instead, labour taxation (followed by consumption taxation) is the optimal configuration.
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Optimal fiscal and monetary policy, debt crisis, and management

Optimal fiscal and monetary policy, debt crisis, and management

We investigate these issues through the lens of a Dynamic Stochastic General Equilibrium (DSGE) model, paying particular attention to the subtle interactions between fiscal and mon- etary policy. The core of the model is a fairly standard New-Keynesian (NK) model featuring frictions as in Smets and Wouters (2007) with price and nominal wage rigidity. This basic set-up is augmented with a detailed fiscal sector, which is instrumental for our analysis of monetary and fiscal interactions. First, the government finances its expenditures by raising a mix of lump-sum and distortionary taxes and by issuing government bonds. Second, holding government debt is subject to sovereign default risk. Third, government expenditures are utility-enhancing and we allow for a versatile private-public consumption aggregator encom- passing substitutability or complementarity. Although most of the analysis is conducted in a framework in which the government only issues short-term bonds, we provide an extension al- lowing the government to also issue long-term bonds. We use US data to calibrate parameter values and shocks in the model, in order to match key stylized facts and minimize a weighted loss function of key volatilities and correlations.
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Optimal Monetary and Fiscal Policy with Migration in a Currency Union

Optimal Monetary and Fiscal Policy with Migration in a Currency Union

More recently, Farhi and Werning (2014) also study migration in a currency union, but in a different type of model with nominal rigidities and internal imbalances. They also show how migration out of depressed regions may produce a positive spillover for stayers. Relative to this study, we model a currency union without nominal rigidities and emphasize search and information frictions that generate both a motive for migration and a role for monetary policy. In addition, we focus on household mobility that affects the location where resources are spent, rather than labor mobility that affects the location where income is generated. Moreover, we consider monetary policy in conjunction with one fiscal instrument (a tax on profits in frictional markets), whereas they consider two fiscal instruments (labor and profit taxes) but no monetary policy and design the optimal policy mix to alleviate regional distortions from migration.
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Optimal monetary and fiscal policy in a currency union

Optimal monetary and fiscal policy in a currency union

To the extent that price stickiness is present ( > 0), there are welfare losses associ- ated with departures from price stability, in addition to those stemming from nonzero output and …scal gaps. However -as discussed above- the ‡exible price/e¢ cient al- location is not feasible under the currency union regime. In particular, the rise in productivity must be absorbed only via a gradual and persistent fall in the price level, with the consequent relative price distortions. As a result, the optimal policy mix requires expanding the …scal gap to bring about the rise in demand necessary to accommodate the desired expansion in output, thus smoothing the adjustment of prices over time. To see that formally, notice that in the equilibrium under the optimal policy equation (46) simpli…es to:
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Optimal Monetary Policy, Gains from Commitment, and Inflation Persistence

Optimal Monetary Policy, Gains from Commitment, and Inflation Persistence

e¤ects on the current in‡ation. Thus, the bene…ts from commitment reduce rapidly. The di¤erence in the behavior between commitment and discretion can be seen more clearly in Figure 7, which shows the impulse-response functions of in‡ation rate, output gap and nominal interest rates to an annualized one-percentage-point cost-push shock when ½ = 0. In Figures 7, 8, and 10, the output gap is measured in percentage deviations from the steady state, and the in‡ation rate and the nominal interest rate are measured in annualized percentage points (expressed as deviations from a steady state with positive values). Under discretion or commitment, the shock leads to an increase in the in‡ation rate and nominal interest rate and to a reduction in the output gap (note that the scales of the graphs are di¤erent). The monetary authority raises the interest rate in order to lower the output gap, and thereby to reduce the in‡ationary pressure. Since the shock lasts for only one period, the output-gap response under discretion has the same duration. Under commitment, however, the output-gap reduction persists for a longer period. It is the “output cost” of commitment: even after the shock dies out, output falls because of its e¤ects on the in‡ation rate in the initial period. It is evident the time inconsistency of the commitment solution. After collecting the gains in the …rst period (i = 0), a reoptimization at i = 1 generates x t+1 = 0 as the output-gap
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Optimal Fiscal and Monetary Policy Without Commitment

Optimal Fiscal and Monetary Policy Without Commitment

The present paper contributes to a growing literature in macroeconomics that explores the properties of optimal policies under discretion. For example, in a recent paper, D´ıaz-Gim´ enez et al. (2008) study optimal time-consistent fiscal and monetary policies in a deterministic setting with flexible prices and perfectly competitive markets. They point out the difficulty of credibly implementing non-inflationary policies in economies with outstanding nominal public debt, as governments are tempted to inflate in order to reduce the real value of their liabilities. In a similar environment, Martin (2007) provides a positive theory of government debt. He shows that the long-run level of debt is determined such that the sequential policy maker does not face incentives to employ the inflation tax. In particular, the sign and the size of the steady state level of government debt is determined by the relative ease/difficulty for households to substitute away from goods subject to the inflation tax. Moreover, time-consistent policies have also been studied extensively in the context of optimal taxation and fiscal policy. Recent contributions include Klein and R´ıos-Rull (2003), Klein et al. (2005), Klein et al. (2007), Ortigueira (2006), and Ortigueira and Pereira (2007). However, all these papers are predominantly concerned with the characterization and computation of Markov-perfect optimal policies in deterministic environments. To the best of our knowledge, the present paper is the first one that characterizes the cyclical properties of monetary and fiscal policies in a stochastic economy governed by an authority that lacks commitment power.
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Commitment versus discretion in monetary policy

Commitment versus discretion in monetary policy

If we focus on situations where everyone behaves in a similar fashion, there are two potential outcomes. Everyone believes that no one else will build near the water; no one does; and no dam is built. That is the optimal outcome and the one obtained under commitment. If, however, everyone believes that others will build near the water, everyone does build near the water, and a dam is built — a less than desirable outcome. An important thing to note is how complicated an individual’s decision-making process is. He must factor in not only what he believes the government will do but what everyone else will do as well. It is precisely this feature of how expectations affect an individual’s decision that leads to the less desirable results under discretion. I will return to this aspect of behavior when I discuss monetary policy.
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Optimal Simple Rules for Fiscal Policy in a Monetary Union

Optimal Simple Rules for Fiscal Policy in a Monetary Union

The optimal policy minimizes the loss function (29) given the equations (25) and (27). Its implementation faces two potential problems, however. Firstly, full optimization requires the policy maker to have perfect knowledge about the model structure. The second problem is the time consistency of optimal policy under delayed implementation. Simple policy rules can mitigate both problems (see Levin et al. 1999, Taylor 1999). They require less information about the economic environment, and they are less vulnerable to variations in economic struc- ture. 6 Furthermore, simple rules are easy to understand and transparent. The commitment to a simple rule is thus easier to observe and to implement than the commitment to the fully opti- mal plan (see Beetsma and Jensen 2002, Dieppe et al. 2005). We focus our discussion on simple rules of the form (30). Fiscal policy reacts to the output gap and to inflation in domes- tic goods prices. For the reaction is contemporaneous, i.e. without implementation lag.
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The Optimal Degree of Discretion in Monetary Policy

The Optimal Degree of Discretion in Monetary Policy

Here we have assumed that the monetary authority maximizes the welfare of society. As such, the monetary authority is viewed as the conduit through which society exercises its will. An alternative approach is to view the monetary authority as an individual or an organization motivated by concerns other than that of society’s well-being. If, for example, the monetary authority is motivated in part by its own wages, then, as Walsh (1995) has shown, it is possible to implement the full-information, full-commitment solution. Hence, with such a setup, there are no binding incentive problems in monetary policy to begin with. As Persson and Tabellini (1993) note, there are a host of reasons such contracts are either difficult or impossible to implement, and the main issue for research following this approach is why such contracts are, at best, rarely used.
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A fiscal stimulus with deep habits and optimal monetary policy

A fiscal stimulus with deep habits and optimal monetary policy

A modelling device that has been used to obtain the consumption crowding-in and higher fiscal multi- pliers in Real Business Cycle (RBC) models is the assumption that external ‘deep habits’ à la Ravn et al. (2006) are formed in private and public consumption, i.e. habits on the average consumption level of each variety of goods. Jacob (2012) shows that in a New-Keynesian (NK) model with deep habits, increasing degrees of price stickiness soften the expansionary effects of a fiscal stimulus and may overturn the results obtainable in a RBC model.

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Optimal monetary and fiscal policy in economies with multiple distortions

Optimal monetary and fiscal policy in economies with multiple distortions

thumb. Second, we assume that the government has only access to distortive means of raising revenue. This endogenizes the dynamics of the tax rate and thereby we have an environment in which jointly optimal monetary and …scal policy strategies are de- termined to be pursued by the respective branches of government in a coordinated fashion. In such a setup, in‡ation plays a role in meeting the long-run …scal solvency requirement and at the same time the dynamic of the tax rate a¤ects price stabil- ity through its impact on marginal cost and the natural rate of output. Third, we do not assume that a subsidy is available to eliminate the distortive e¤ects of excess market power or government policies, commonly used in analyses of monetary pol- icy following Rotemberg and Woodford (1999), and allow for large departures from the hypothetical steady state attained in …rst-best economies. Relaxing this assump- tion incorporates the level e¤ects of stabilization policy in the analysis. The last two features of the model distinguish our analysis from Bilbiie (2005) who models an econ- omy with liquidity constrained agents but his analysis concentrates on the monetary side only and assumes that the steady state of the economy can be made e¢cient.
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Optimal monetary and fiscal policy: a linear-quadratic approach

Optimal monetary and fiscal policy: a linear-quadratic approach

implementing the optimal equilibrium. In particular, we seek to characterize optimal policy in terms of optimal targeting rules for monetary and fiscal pol- icy, of the kind proposed in the case of monetary policy by Svensson (1999), Svensson and Woodford (2003), and Giannoni and Woodford (2002, 2003). The rules are specified in terms of a target criterion for each authority; each authority commits itself to use its policy instrument each period in whatever way is necessary in order to allow it to project an evolution of the economy consistent with its target criterion. As discussed in Giannoni and Woodford (2002), we can derive rules of this form that are not merely consistent with the desired equilibrium responses to disturbances, but that in addition (i) imply a determinate rational-expectations equilibrium, so that there are not other equally possible (but less desirable) equilibria consistent with the same policy; and (ii) bring about optimal responses to shocks regardless of the character of and statistical properties of the exogenous disturbances in the model.
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On optimal monetary and fiscal policy interactions in open economies

On optimal monetary and fiscal policy interactions in open economies

The key difference with respect to the open economy literature is that the fiscal policy instrument is not government expenditure. The key difference with respect to the closed economy one is the presence of lump sum taxes. This simplifying assumption allows to keep the model tractable. But, more importantly, it surfaces the following implication of the two country framework: when prices are flexible, non-cooperative fiscal policy authorities have an incentive to use tax rates strategically in order to influence the terms of trade. In fact, under complete markets, being consumption equal across countries, non-cooperative fiscal planners seek to externalize output production by adjusting firm tax rates. Because of this incentive, despite the presence of the lump sum taxes, optimal firm tax rates are state dependent. As a consequence when fiscal policy is set non-cooperatively there is a motive for endogenous movements of the wedge in the marginal rate of substitution between consumption and good production which turn out to matter for monetary policy decisions. If fiscal policy is set non- cooperatively the cooperative optimal monetary policy maker does not implement the flexible price allocation while, when fiscal policy is set cooperatively, implementing the flexible price allocation is always optimal. Which is the optimal coordinated monetary policy depends on the fiscal policy regime.
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