Scandinavian Working Papers in Economics

Research Papers in Economics,
Stockholm University, Department of Economics

No 2002:17: On (Sub) Optimal Monetary Policy Rules under Untied Fiscal Hands

Paolo Zagaglia ()
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Paolo Zagaglia: Dept. of Economics, Stockholm University, Postal: Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden

Abstract: We examine the interplay between monetary and fiscal policies in a context where disturbances to the public deficit process are a primary source of macroeconomic instability. We perform simulations of optimal targeting rules on a sticky-price model `a la Woodford (1997). Our investigation compares the dynamic adjustment path under inflation targeting with that arising from nominal income growth targeting. When fiscal shocks enter the picture, inflation targeting is a superior strategy. In opposition to Jensen (2002)’s results, we show that an inflation targeter is capable of bringing about the required degree of interest rate inertia. This does not occur at the cost of additional nominal instability.

Keywords: interest rate smoothing; monetary policy rules; fiscal shocks

JEL-codes: E52; E63

29 pages, September 23, 2002

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