Optimal Fiscal and Monetary Policy in a Medium-Scale Macroeconomic Model

In this paper, we study Ramsey-optimal fiscal and monetary policy in a medium-scale model of the US business cycle. The model features a rich array of real and nominal rigidities that have been identified in the recent empirical literature as salient in explaining observed aggregate fluctuations. The main result of the paper is that price stability appears to be a central goal of optimal monetary policy. The optimal rate of inflation under an income-tax regime is ½ percent per year, with a volatility of 1.1 percent. This result is surprising given that the model features a number of frictions-particularly nonstate-contingent nominal public debt, no lump-sum taxes, and sticky wages-that, in isolation, would call for a volatile rate of inflation. Under an income-tax regime, the optimal income-tax rate is quite stable, with a mean of 30 percent and a standard deviation of 1.1 percent. Simple monetary and fiscal rules are shown to implement a competitive equilibrium that mimics well the one induced by the Ramsey policy. When the fiscal authority is allowed to tax capital and labor income at different rates, optimal fiscal policy is characterized by a large and volatile subsidy on capital.