This article focuses on the interaction, in a stylized economy with flexible prices, of monetary and fiscal policy when both are active-active in the sense that how the policy instrument is set depends on the state of the economy. Fiscal policy finances a given stream of government expenditures through distortionary labor taxes, and it operates under a strict balanced-budget rule. If monetary policy is passive, the economy may occasionally switch, because of self-fulfilling expectations, from the neighborhood of a "Laffer trap" equilibrium to the saddle-path leading to the high-welfare steady state. In the low-welfare stationary state, output, investment, and consumption are low while the tax rate is correspondingly high. However, active monetary policy may, by following a rule such that the nominal interest rate responds positively to the state of the economy, push the economy toward the high-welfare equilibrium and rule out expectation-driven business cycles.
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Article provided by Federal Reserve Bank of St. Louis in its journal Review.
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Marta Aloi & Teresa Lloyd-Braga & Hans Jørgen Whitta-Jacobsen, 2003.
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International Economic Review,
Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(3), pages 895-915, 08.
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Kemp, Murray C & Long, Ngo Van & Shimomura, Koji, 1993.
"Cyclical and Noncyclical Redistributive Taxation,"
International Economic Review,
Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 34(2), pages 415-29, May.
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Gaetano Antinolfi & Costas Azariadis & James B. Bullard, 2007.
"Monetary policy as equilibrium selection,"
Review,
Federal Reserve Bank of St. Louis, issue Jul, pages 331-342.
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