Staff Report 251

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Optimal Fiscal and Monetary Policy

V. V. Chari - Consultant
Patrick J. Kehoe

Published July 1, 1998

Abstract
We provide an introduction to optimal fiscal and monetary policy using the primal approach to optimal taxation. We use this approach to address how fiscal and monetary policy should be set over the long run and over the business cycle. We find four substantive lessons for policymaking: Capital income taxes should be high initially and then roughly zero; tax rates on labor and consumption should be roughly constant; state-contingent taxes on assets should be used to provide insurance against adverse shocks; and monetary policy should be conducted so as to keep nominal interest rates close to zero. We begin optimal taxation in a static context. We then develop a general framework to analyze optimal fiscal policy. Finally, we analyze optimal monetary policy in three commonly used models of money: a cash-credit economy, a money-in-the-utility-function economy, and a shopping-time economy.


Published In: Handbooks in Economics (Vol. 1C, 1999, pp. 1671-1745)

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