English, Article, Journal or magazine article edition: Optimal Inflation Targeting under Alternative Fiscal Regimes Pierpaolo Benigno; Michael Woodford

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Physical Description
  • preprint
Language
  • English

Edition details

Title
  • Optimal Inflation Targeting Under Alternative Fiscal Regimes
Author
  • Pierpaolo Benigno
  • Michael Woodford
Physical Description
  • preprint
Notes
  • Standard discussions of flexible inflation targeting as an optimal monetary policy abstract completely from the consequences of monetary policy for the government budget. But at least some of the countries now adopting inflation targeting have substantial difficulty in controlling fiscal imbalances, so that the additional strains resulting from strict control of inflation are of substantial concern, and some (notably Sims 2005) have argued that inflation targeting can even be counterproductive under some fiscal regimes. Here, therefore, we analyze welfare-maximizing monetary policy taking explicit account of the consequences of monetary policy for the government budget, and under a variety of assumptions about the nature of the fiscal regime. The paper contrasts the optimal monetary policies under three alternative assumptions about fiscal policy: (i) the case in which little distortion is required to raise additional government revenue, and the fiscal authority can be relied upon to ensure intertemporal government solvency [the implicit assumption in standard analyses]; (ii) the case in which only distorting sources of revenue exist, but distorting taxes are adjusted optimally; and (iii) the case in which tax rates cannot be expected to change in response to a change in monetary policy [the problematic case emphasized by Sims]. In both of cases (ii) and (iii), it is optimal for monetary policy to allow the inflation rate to respond to fiscal developments (and the optimal responses to other shocks are somewhat different than in the classic analysis, which assumes case (I)). Nonetheless, optimal monetary policy can still be implemented through a form of flexible inflation targeting, and it remains critical, even in the most pessimistic case (case (iii)), that inflation expectations (beyond some very short horizon) not be allowed to vary in response to shocks.
  • RePEc:nbr:nberwo:12158
  • Flexible inflation targeting has been advocated as a practical approach to the implementation of an optimal state-contingent monetary policy, but theoretical expositions reaching this conclusion have typically abstracted from the fiscal consequences of monetary policy. Here we extend the standard theory by considering the character of optimal monetary policy under a variety of assumptions about the fiscal regime, with the standard analysis appearing only as a special case in which non-distorting sources of government revenue exist, and fiscal policy can be relied upon to adjust so as to ensure intertemporal government solvency. Alternative cases treated in this paper assume that there exist only distorting sources of government revenue; that it may not be possible for tax rates to adjust in response to economic disturbances, except with delay; or even that fiscal policy is purely exogenous, so that the central bank cannot rely upon fiscal policy to adjust in order to maintain intertemporal solvency (a case emphasized in the critique of inflation targeting by Sims, 2005). We find that the fiscal policy regime has important consequences for the optimal conduct of monetary policy, but that a suitably modifed form of inflation targeting will still represent a useful approach to the implementation of optimal policy. We derive an optimal targeting rule for monetary policy that applies to all of the fiscal regimes considered in this paper, and show that it involves commitment to an explicit target for an output-gap adjusted price level. The optimal policy will allow temporary departures from the long-run target rate of growth in the gap-adjusted price level in response to disturbances that affect the government's budget, but it will also involve a commitment to rapidly restore the projected growth rate of this variable to its normal level following such disturbances, so that medium-term inflation expectations should remain firmly anchored despite the occurrence of fiscal shocks.
  • RePEc:clu:wpaper:0506-09
  • Flexible inflation targeting has been advocated as a practical approach to the implementation of an optimal state-contingent monetary policy, but theoretical expositions reaching this conclusion have typically abstracted from the fiscal consequences of monetary policy. Here we extend the standard theory by considering the character of optimal monetary policy under a variety of assumptions about the fiscal regime, with the standard analysis appearing only as a special case in which non-distorting sources of government revenue exist, and fiscal policy can be relied upon to adjust so as to ensure intertemporal government solvency. Alternative cases treated in this paper include ones in which there exist only distorting sources of government revenue; and also ones in which fiscal policy is purely exogenous, so that the central bank cannot rely upon fiscal policy to adjust in order to maintain intertemporal solvency (a case emphasized in the critique of inflation targeting by Sims, 2005). We find that the fiscal policy regime has important consequences for the optimal conduct of monetary policy, but that a suitably modified form of inflation targeting will still represent a useful approach to the implementation of optimal policy. We derive an optimal targeting rule for monetary policy that applies to all of the fiscal regimes considered in this paper, and show that it involves commitment to an explicit target for an output-gap adjusted price level. The optimal policy will allow temporary departures from the long-run target rate of growth in the gap-adjusted price level in response to disturbances that affect the government’s budget, but it will also involve a commitment to rapidly restore the projected growth rate of this variable to its normal level following such disturbances, so that medium-term inflation expectations should remain firmly anchored despite the occurrence of fiscal shocks.
  • RePEc:chb:bcchwp:407
Language
  • English
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