When is monetary policy all we weed?

Working paper

We consider optimal monetary and fiscal policies in a New Keynesian model of a small open economy with sticky prices and wages. In this benchmark setting monetary policy is all we need - analytical results demonstrate that variations in government spending should play no role in the stabilization of shocks. In extensions we show, firstly, that this is even true when allowing for inflation inertia through backward-looking rule-of-thumb price and wage-setting, as long as there in no discrepancy between the private and social evaluation of the marginal rate of substitution between consumption and leisure. Secondly, the optimal neutrality of government spending is robust to the issuance of public debt. In the presence of debt government spending will deviate from the optimal steady-state but only to the extent required to cover the deficit, not to provide any additional macroeconomic stabilization. However, unlike government spending variations in tax rates can play a complementary role to monetary policy, as they change relative prices rather than demand.

Authors: Wren-Lewis, S; Eser, F

• Publication status: Published
• Publisher: University of Oxford
• Series: Department of Economics Discussion Paper Series
• Publication date: 2009-05-01
• Paper number: 430
• Keywords: macroeconomic stabilization; countercyclical policy; monetary policy; sticky wages; rule-of-thumb; sticky prices; behaviour; fiscal policy; dynamic general equilibrium; debt