Operational Fiscal and Monetary Policy with Staggered Wage and Price Dynamics

I consider the optimal setup of simple rules for monetary and tax policy in a model with distortionary taxes, wage and price stickiness. The rules maximize a measure of households’ intertemporal utility. The model is solved through the second-order approximation method of Schmitt-Grohé and Uribe (2004). When both prices and wages are indexed to steady-state inflation, the average tax rate responds little to government liabilities. This arises from the need to minimize the inefficient distortions arising from fluctuations in the price level for fiscal reasons. Optimal monetary policy responds strongly to changes in wages. In an economy with only wage rigidity, fiscal considerations prevail over the need to stabilize wage fluctuations, and the policy mix produces a large variability of inflation. Finally, with indexation of wages and prices to lagged inflation, the dynamic behavior of the economy is closer to the frictionless equilibrium, and the optimal policy mix resembles the one under flexible prices and sticky wages.