Optimal Fiscal Stabilisation through Government Spending

This paper examines under what conditions fiscal policy in the form of government spending should contribute to macroeconomic stabilisation. To this end optimal fiscal targeting rules minimising the microfounded social loss are examined in the following settings. Firstly, for the benchmark New Keynesian model, where monetary policy is unconstrained, a neutrality result for fiscal obtains: fiscal policy should not respond to any shocks. Secondly, if monetary policy is constrained to follow a Taylor rule, a stabilisation role for fiscal policy emerges. Fiscal policy should 'lean against' inflation and be countercyclical relative to output. Crucially, the Taylor principle is shown to remain the key requirement on policy to guarantee equilibrium determinacy. Thirdly, the fiscal targeting rule obtained under a Taylor rule is shown to be optimal, too, when policy is optimal but subject to monetary frictions. Thus, there is a stabilisation role for government spending under monetary frictions, changing the role of monetary and fiscal policy fundamentally.