Distortionary taxation and interest rate policy

Abstract

In a cashless economy with strictly inflation-forecast-targeting interest rate policy, recent research shows that in the presence of distorting taxes, a balanced-budget taxation policy is likely to induce indeterminacy of equilibrium but a debt-targeting one is not, suggesting that short-run budget deficits play a role in stabilizing the economy. The present paper finds that this result is overturned in a monetary economy with flexibly inflation-forecast-targeting interest rate policy. The balanced-budget policy is likely to ensure determinacy together with the flexibly inflation-forecast-targeting policy, but the debt-targeting one may lead to indeterminacy in the monetary economy.