Jointly optimal monetary and fiscal policy rules under liquidity constraints

In most cases authors are permitted to post their version of the article (e.g. in Word or Tex form) to their personal website or institutional repository. Authors requiring further information regarding Elsevier's archiving and manuscript policies are encouraged to visit: JEL classification: E32 E52 E62 E63 Keywords: Optimal simple policy rules Timeless perspective optimal policy Monetary policy rules Fiscal policy rules Welfare analysis Liquidity constraints a b s t r a c t We study the welfare properties of an economy where both monetary and fiscal policies follow simple rules, and where a subset of agents is liquidity constrained. The welfare benefits of optimizing the fiscal rule are far larger than those of optimizing the monetary rule. The optimized fiscal rule implements strong automatic stabilizers that primarily stabilize the income of liquidity-constrained agents, rather than output. Transfers targeted to liquidity constrained agents are the preferred fiscal instrument. The optimized monetary rule exhibits super-inertia and a weak inflation response. Optimized simple rules perform as well as the optimal policy under the timeless perspective. In the wake of the recent financial crisis we have seen a lively debate concerning the merits of activist fiscal policy. Given the perceived urgency of preventing a deep recession, the initial attention was mostly focused on the pros and cons of fiscal stimulus measures, but some attention is now shifting to the need for longer run sustainability. Remarkably though, the economics profession entered this period of turmoil with few analytical tools to think about the systematic use of fiscal policy in response to the business cycle. Specifically, and unlike the monetary policy literature since Taylor (1993), there was little work on rules-based fiscal policy. This is where our paper attempts to make a contribution, by proposing and evaluating a novel and simple policy rule whereby the fiscal surplus to GDP ratio responds to a tax revenue gap. The paper studies the welfare consequences of jointly optimizing this fiscal rule and a conventional monetary rule, in an economy where a subset of households is liquidity constrained. We show that, despite its simplicity, our rule is able to match the welfare performance of the optimal policy from the timeless perspective. Taylor (2000) discusses a fiscal rule in which the budget surplus responds to the output gap. He advises against it, and argues that the role of fiscal policy should be limited to ''letting automatic stabilizers work'' .