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Optimal Monetary Policy Response to Distortionary Tax Changes

Author

Listed:
  • Michael Krause

    (Department of Economics Deutsche Bundesbank)

  • Wolfgang Lemke

    (Department of Economics Deutsche Bundesbank)

Abstract

We analyze the trade-offs faced by a monetary policy authority when a value added tax rate is increased. In the short run, such an increase acts as a cost push shock from the perspective of a central bank that is concerned with stabilizing the welfare relevant output gap. We develop a New Keynesian monetary model with real wage rigidity and consider the effects that obtain under a simple interest rate rule, on the one hand, and those that obtain under an optimal monetary policy from a timeless perspective (in the terminology of Woodford, 2003). The implications for the dynamic response of the economy differ in the presence of real wage rigidity. While under a rule inflation is higher for about eight quarters, the optimal policy involves an adjustment that is about half as long, and is followed by a slight deflation. The reason is that this policy can be shown to include a commitment to target a certain price-level, which helps contain inflation expectations. We treat the tax shock as permanent, so that the central bank does not fully revert the price level to its orginal level.

Suggested Citation

  • Michael Krause & Wolfgang Lemke, 2006. "Optimal Monetary Policy Response to Distortionary Tax Changes," Computing in Economics and Finance 2006 306, Society for Computational Economics.
    • Handle: RePEc:sce:scecfa:306
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    File URL: http://repec.org/sce2006/up.31421.1141070174.pdf
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    References listed on IDEAS

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    1. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
    2. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
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    4. Dewatripont,Mathias & Hansen,Lars Peter & Turnovsky,Stephen J. (ed.), 2003. "Advances in Economics and Econometrics," Cambridge Books, Cambridge University Press, number 9780521818728, September.
    5. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    6. Olivier Blanchard & Jordi Galí, 2007. "Real Wage Rigidities and the New Keynesian Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(s1), pages 35-65, February.
    7. Galí, Jordi, 2002. "New Perspectives on Monetary Policy, Inflation and the Business Cycle," CEPR Discussion Papers 3210, C.E.P.R. Discussion Papers.
    8. Dewatripont,Mathias & Hansen,Lars Peter & Turnovsky,Stephen J. (ed.), 2003. "Advances in Economics and Econometrics," Cambridge Books, Cambridge University Press, number 9780521524131, September.
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    13. Sims, Christopher A, 2002. "Solving Linear Rational Expectations Models," Computational Economics, Springer;Society for Computational Economics, vol. 20(1-2), pages 1-20, October.
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    16. Walsh, Carl E., 2005. "Endogenous objectives and the evaluation of targeting rules for monetary policy," Journal of Monetary Economics, Elsevier, vol. 52(5), pages 889-911, July.
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    Cited by:

    1. Sebastian Sienknecht, 2010. "On the Informational Loss Inherent in Approximation Procedures: Welfare Implications and Impulse Responses," Jena Economics Research Papers 2010-005, Friedrich-Schiller-University Jena.

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    More about this item

    Keywords

    Nominal and real rigidities; distortionary taxation; optimal monetary policy;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • 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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