Optimal time-consistent monetary and fiscal policy under sticky prices

This paper studies optimal monetary and fiscal policy in a stochastic economy with sticky prices and monopolistic competition on its product markets. Our main objective is to characterize optimal time-consistent (Markov) policies and to compare their characteristics to the ones implemented by a Ramsey policy maker. We perform this comparison within the framework of a stochastic production economy where the real value of the government’s net wealth/indebtedness is an endogenous state variable. Our main findings are the following: (i) the dynamic properties of the Ramsey allocation depend on the relevant steady state; (ii) at the steady state endogenously selected by the Markovian policy maker, the dynamic properties of the Ramsey and the Markov allocation differ in important aspects; (iii) variations in the degree of price stickiness and market power have qualitatively similar effects on both the Ramsey and the Markov allocation; (iv) variations in preference parameters have important implications for the implemented steady state allocation. The key mechanism behind these results is the fact that the Markovian policy maker selects the steady state in a way such as to do away with with the incentive constraints due to sequential policy implementation.