Optimal inflation targeting under alternative fiscal regimes

NBER WORKING PAPER SERIES

OPTIMAL INFLATION TARGETING UNDER ALTERNATIVE FISCAL REGIMES
Pierpaolo Benigno
Michael Woodford
Working Paper 12158 http://www.nber.org/papers/w12158 NATIONAL BUREAU OF ECONOMIC RESEARCH
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 earlier draft, 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 quoted without 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
ABSTRACT
Standard discussions of flexible inflation targeting as an optimal monetary policy abstract completely from the consequences 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 fiscal regimes. 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 to