Optimal Fiscal and Monetary Policy with Sticky Prices∗

In this paper, I study the properties of the Ramsey equilibrium in a model with distortionary taxation, nominal non-state-contingent debt, and costs of surprise inßation. To do this, I modify the standard cash-credit good economy studied in the optimal policy literature to include sticky prices. With this modiÞcation, the Ramsey planner must balance the shock absorbing beneÞts of surprise inßation against the associated resource misallocation costs. The results of this modiÞcation are striking, as introducing price rigidity generates large departures from the case with fully ßexible prices. For even small amounts of price stickiness, optimal monetary policy displays very little volatility in inßation. Optimal tax rates display much greater volatility than with fully ßexible prices. The Friedman Rule is no longer optimal, as the nominal interest rate ßuctuates across states of nature in the Ramsey equilibrium. Finally, optimal tax rates and real debt holdings no longer inherit the serial correlation properties of the underlying shocks; with sticky prices, these variables exhibit behavior similar to a random walk. JEL Classification: E52, E63, H21