Welfare Maximizing Fiscal and Monetary Policy Rules

Abstract

This paper studies the welfare effects of monetary and fiscal policy rules, in a dynamic general equilibrium model with sticky prices. The model features capital accumulation and endogenous labor effort, and exogenous productivity shocks. Government purchases are valued positively by the private sector. These purchases are financed using a proportional income tax. The government issues nominal one-period bonds. Monetary policy is described by an interest rate rule; fiscal policy is described by rules according to which the income tax rate and government purchases are set as functions of GDP. Sims' (2000) quadratic approximation method is used to solve the model, and to compute household welfare. The paper determines the response coefficients of the policy rules that maximize household welfare. Optimized monetary policy has a strong anti-inflation stance; optimized fiscal policy implies that the income tax rate is countercyclical, and that government purchases are procyclical; this result does not hinge on the degree of price stickiness. .

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