Optimal inflation targeting under alternative fiscal regimes

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Pierpaolo Benigno
Michael Woodford
Working Paper 12158
1050 Massachusetts Avenue
Cambridge, MA 02138
April 2006

We thank Romulo Chumacero, Norman Loayza, Eduardo Loyo, and Klaus Schmidt-Hebbel for useful
comments on an earlierdraft, Vasco Curdia and Mauro Roca for research assistance, and the National
Science Foundation for research support. The views expressed herein are those of the author(s) and do not
necessarily reflect the views of the National Bureau of Economic Research.
©2006 by Pierpaolo Benigno and Michael Woodford. All rights reserved. Short sections of text, not to
exceed two paragraphs, may be quotedwithout explicit permission provided that full credit, including ©
notice, is given to the source.

Optimal Inflation Targeting under Alternative Fiscal Regimes
Pierpaolo Benigno and Michael Woodford
NBER Working Paper No. 12158
April 2006
JEL No. E52, E63
Standard discussions of flexible inflation targeting as an optimal monetary policy abstract
completely from theconsequences of monetary policy for the government budget. But at least some
of the countries now adopting inflation targeting have substantial difficulty in controlling fiscal
imbalances, so that the additional strains resulting from strict control of inflation are of substantial
concern, and some (notably Sims 2005) have argued that inflation targeting can even be
counterproductive under some fiscalregimes. Here, therefore, we analyze welfare-maximizing
monetary policy taking explicit account of the consequences of monetary policy for the government
budget, and under a variety of assumptions about the nature of the fiscal regime.
The paper contrasts the optimal monetary policies under three alternative assumptions about fiscal
policy: (i) the case in which little distortion is required toraise additional government revenue, and
the fiscal authority can be relied upon to ensure intertemporal government solvency [the implicit
assumption in standard analyses]; (ii) the case in which only distorting sources of revenue exist, but
distorting taxes are adjusted optimally; and (iii) the case in which tax rates cannot be expected to
change in response to a change in monetary policy[the problematic case emphasized by Sims]. In
both of cases (ii) and (iii), it is optimal for monetary policy to allow the inflation rate to respond to
fiscal developments (and the optimal responses to other shocks are somewhat different than in the
classic analysis, which assumes case (I)). Nonetheless, optimal monetary policy can still be
implemented through a form of flexible inflationtargeting, and it remains critical, even in the most
pessimistic case (case (iii)), that inflation expectations (beyond some very short horizon) not be
allowed to vary in response to shocks.
Pierpaolo Benigno
NYU Department of Economics
269 Mercer Street
New York, NY 10003
and NBER
Michael Woodford
Department of Economics
Columbia University
420 W. 118th Street
NewYork, NY 10027
and NBER

Since its adoption in Chile and elsewhere early in the 1990s, inflation targeting
has become an increasingly popular approach to the the conduct of monetary policy
worldwide. Most of the countries that have adopted inflation targeting judge the
experiment favorably, at least thus far. In many countries the adoption of inflationtargeting has been associated with reductions in both the average level and volatility
of inflation. Inflation targeting has been especially successful in stabilizing inflation
expectations,1 as one might expect, given the emphasis that is typically given to a
clear medium-term commitment regarding inflation (while temporary departures from
the inflation target are allowed), and the typical increase in...