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Targeting inflation and the fiscal balance : what is the optimal policy mix?

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  • Marcela Meirelles Aurelio

Abstract

This paper identifies optimal policy rules in the presence of explicit targets for both the inflation rate and public debt. This issue is investigated in the context of a dynamic stochastic general equilibrium model that describes a small open economy with capital accumulation, distortionary taxation and nominal price rigidities. The model is solved using a second-order approximation to the equilibrium conditions. Optimal policy features a strong anti-inflation stance and strict fiscal discipline. Targeting a domestic inflation index - as opposed to CPI - improves welfare because it reduces the inefficiencies that stem from both price stickiness and income taxes.

Suggested Citation

  • Marcela Meirelles Aurelio, 2006. "Targeting inflation and the fiscal balance : what is the optimal policy mix?," Research Working Paper RWP 06-07, Federal Reserve Bank of Kansas City.
    • Handle: RePEc:fip:fedkrw:rwp06-07
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    Keywords

    Inflation (Finance); Prices; Fiscal policy;
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