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Operational Fiscal and Monetary Policy with Staggered Wage and Price Dynamics

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  • Paolo Zagaglia

    (Stockholm University and European Central Bank)

Abstract

I consider the optimal setup of simple rules for monetary and tax policy in a model with distortionary taxes, wage and price stickiness. The rules maximize a measure of households’ intertemporal utility. The model is solved through the second-order approximation method of Schmitt-Grohé and Uribe (2004). When both prices and wages are indexed to steady-state inflation, the average tax rate responds little to government liabilities. This arises from the need to minimize the inefficient distortions arising from fluctuations in the price level for fiscal reasons. Optimal monetary policy responds strongly to changes in wages. In an economy with only wage rigidity, fiscal considerations prevail over the need to stabilize wage fluctuations, and the policy mix produces a large variability of inflation. Finally, with indexation of wages and prices to lagged inflation, the dynamic behavior of the economy is closer to the frictionless equilibrium, and the optimal policy mix resembles the one under flexible prices and sticky wages.

Suggested Citation

  • Paolo Zagaglia, 2007. "Operational Fiscal and Monetary Policy with Staggered Wage and Price Dynamics," Finnish Economic Papers, Finnish Economic Association, vol. 20(2), pages 121-138, Autumn.
    • Handle: RePEc:fep:journl:v:20:y:2007:i:2:p:121-138
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    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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