Fiscal policy and optimal monetary rules in a non-Ricardian economy

Abstract

We study in this article how the conduct of fiscal policy interacts with the choice of optimal monetary rules by a central bank. We consider a non-Ricardian model with nondistortionary fiscal policies, and compare two policy packages, one where fiscal and monetary policies are simultaneously optimized, and one where monetary policy is optimized under a given fiscal policy. We find a number of results that would not appear in the traditional Ricardian framework: (a) the optimal monetary rule may be activist when fiscal policy is kept inactive, whereas it is not when combined with optimal fiscal policy; (b) combining optimally fiscal and monetary policies may lead to far superior outcomes, even when, following Sargent and Wallace (1975, Journal of Political Economy 83, 241–254), government is allowed to react to much less information.