Much of our recent research has been devoted to developing and applying tools for the evaluation of macroeconomic stabilization policy. This choice of topic is motivated by the fact that by the late 1990s empirical research using macroeconomic data from industrialized countries had cast compelling doubts on the ability of the neoclassical growth model to provide a satisfactory account of aggregate fluctuations. As a response, the new Keynesian paradigm emerged as an alternative framework for understanding business cycles. One key difference between the neoclassical and the new Keynesian paradigms is that in the latter, the presence of various nominal and real distortions provides a meaningful role for stabilization policy, opening the door once again, after decades of dormancy, for policy evaluation.
Optimal Fiscal and Monetary Policy Under Sticky Prices
A well-known result in macroeconomic theory is that optimal fiscal and monetary policy features smooth distortionary income tax rates and highly volatile and unpredictable inflation rates. The intuition behind this result is straightforward: surprise inflation is equivalent to a lump-sum tax on nominal asset holdings. The Ramsey planner finances innovations in the fiscal budget, such as government spending shocks or unexpected declines in the tax base, through surprise changes in the price level. In this way, distortionary tax rates can be kept relatively stable over time. In calibrated model economies, under the Ramsey policy, the public would be accustomed to seeing inflation rates jumping from -15 percent to +15 percent from one year to the next. This result is completely at odds not only with observed inflation behavior but also with the primary goal of central banks around the world, namely, price stability.
We argue that the price stability goal of central banks can indeed be justified on theoretical grounds. (1) One key assumption of existing studies on optimal monetary and fiscal policy is that there are no impediments to nominal price adjustments. We relax this assumption and instead assume that product prices are sticky.
Obviously, by making price changes costly, we expect to obtain the result that under the Ramsey policy inflation is less volatile than in an economy with flexible prices. But our findings go way beyond our expectations. The introduction of a miniscule amount of price stickiness, less than ten times the degree of price stickiness estimated for the U.S. economy, suffices to make price stability the overriding goal of optimal monetary policy. Specifically, even when firms are assumed to be able to change prices every three to four weeks, the optimal volatility of inflation is below 0.52 percent per year, which is 13 times smaller than the optimal inflation volatility predicted under full price flexibility.
One may naturally expect that the reduced inflation volatility under the Ramsey plan would have to be compensated by increased unpredictability in income tax rates. But this is not the case. The Ramsey planner finances surprises to the fiscal budget mainly through adjustments in the stock of public debt. By using government debt as a shock absorber, the Ramsey planner can smooth tax rates over time. For instance, an unexpected fiscal deficit calls for a permanent increase in debt in the amount of the fiscal deficit and a small but permanent increase in taxes equal in size to the interest payments on the additional debt. Consequently, tax rates and government debt display a near random walk property. It follows that the mere introduction of a small amount of price stickiness resurrects the classical Barro (2) tax-smoothing result. This result stands in contrast to those obtained under flexible prices. In this case, tax rates inherit the stochastic process of the underlying shocks, and thus, in general, will not display the near-random walk property.
Our investigation delivers three additional results of interest for the computation of Ramsey policies. …