Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach

From pages 271-272 -- 'While substantial research literatures seek to characterize optimal monetary and fiscal policy, respectively, the two branches of the literature have largely developed in isolation, and on apparently contradictory foundations. The modern literature on dynamically optimal fiscal policy often abstracts from monetary aspects of the economy altogether and so implicitly 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 distortions that result from the attempt to economize on money balances, and (2) the way the price level varies in response to real disturbances determines the state-contingent real payoffs on (riskless) nominally denominated government debt, which may facilitate tax-smoothing in the case the explicitly state-contingent debt is not available. The literature on optimal monetary policy has instead been mainly concerned with quite distinct objectives for monetary stabilization policy, namely, the minimization of the distortions that result from prices or wages that do not adjust quickly enough to clear markets. At the same time, this literature typically ignores the fiscal consequences of alternative monetary policies; the characterizations of optimal monetary policy obtained are thus strictly correct only for a world in which lump-sum taxes are available. Here we wish to consider the way in which the conclusions reached in each of these two familiar fields of study must be modified if one takes simultaneous account of the basic elements of the policy problems addressed in each. On the one hand, we wish to consider how conventional conclusions with regard to the nature of an optimal monetary policy rule must be modified if one recognizes that the government's only sources of revenue are distorting taxes, so that the fiscal consequences of monetary policy matter for welfare. And, on the other hand, we wish to consider how conventional conclusions with regard to optimal tax policy must be modified if one recognizes that prices do not instantaneously clear markets, so that output determination depends on aggregate demand, in addition to the supply-side factors stressed in the conventional theory of optimal taxation.