Optimal fiscal and monetary policy under sticky prices

Abstract

This paper studies optimal fiscal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing nominal non-state-contingent bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates) the optimal volatility of inflation is near zero. Second, small deviations from full price flexibility induce near random walk behavior in government debt and tax rates. Finally, price stickiness induces deviation from the Friedman rule.