Monetary Policy, Fiscal Policy and Automatic Stabilizers: Welfare and Macroeconomic Stability

This paper analyzes the specific role of fiscal policy on the welfare effects of macroeconomic stabilization policies. We extend current DSGE models à la Schmitt-Grohè and Uribe (2003) to a non-tandard fiscal policy framework. We focus on distortionary and progressive taxation which alters the trade-off between inflation and output stabilization in a non-trivial manner. We develop a DSGE model with nominal rigidities in form of costs of price and wage adjustments. Households have habit preferences in order to introduce a sufficient internal propagation mechanism. The government levies distortionary taxes on both labor and capital income. Fiscal policy is described by a feedback function on outstanding debt. The model is calibrated both for the US economy and for EMU and solved up to a second order approximation. We show that distortionary taxes substantially increase output volatility unless an implausibly high degree of real rigidity is included. We evaluate welfare using the conditional second-order accurate expected utility function. In the class of linear rules, a standard Taylor-type rule is still found to be optimal, but it violates the Taylor principle in that the inflation coefficient is less than one, whereas the output coefficient is considerably bigger than is commonly assumed in the literature. The results do not confirm the findings of Schmitt-Grohè and Uribe (2003), where the optimal output targeting coefficient is found to be negative