Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach

While substantial research literatures seek to characterize optimal mone-tary and fiscal policy, respectively, the two branches of the literature have largely developed in isolation, and on apparently contradictory founda-tions. The modern literature on dynamically optimal fiscal policy often abstracts from monetary aspects of the economy altogether and so implic-itly allows no useful role for monetary policy. When monetary policy is considered within the theory of optimal fiscal policy, it is most often in the context of models with flexible prices. In these models, monetary policy matters only because (1) the level of nominal interest rates (and hence the opportunity cost of holding money) determines the size of certain distor-tions that result from the attempt to economize on money balances, and (2) the way the price level varies in response to real disturbances deter-mines the state-contingent real payoffs on (riskless) nominally denomi-nated government debt, which may facilitate tax-smoothing in the case that explicitly state-contingent debt is not available. The literature on opti