positive effect of reduction of the tax burden on uctuations of macroeconomic aggregates. However, we identify the negative in uence of tax reform aimed at increasing payroll marginal tax rate but keeping the marginal tax wedge constant. Moreover, we identify the mechanism through which this type of tax reforms works when anticipated one period in advance.
1.3 Optimal Monetary and Fiscal Policy and Labour Market
Frictions
The discussion developed in the previous two chapters analyzed aspects of various labour and product market reforms without considering the optimality of policy makers' decision. In the nal chapter we aim to complete the story by analyzing the consequences for the optimal monetary and scal policy mix of various nominal rigidities as well as real labour market rigidities generated by search-matching frictions so far not analyzed in the liter- ature. Before describing our contribution, we summarize the important developments in this eld of analysis.
Most of the standard models used for optimal policy analysis are highly stylized, neglecting many theoretical and policy considerations. One can identify three distinct approaches emerging in the literature. The rst, initiated by Lucas and Stokey (1983), analyses optimal monetary and scal policy in the context of a perfectly competitive ex- ible price environment where the government can issued fully state-contingent debt. The government problem in this setup consists of choosing the least disruptive combinations of in ation and tax rates to nance the exogenous stream of government consumption.
Although there is no real rationale for macroeconomic stabilization policy, several things can be learned from this analysis. First, if there is a suf ciently large set of state contin- gent claims, optimal policy can be made time consistent, although in general the economy will be characterized by time inconsistency. At the same time, if there are nominal claims present even if there are real securities coexisting, the optimal policy in every point of time has the incentive to use in ation to erode the real value of the outstanding debt. The com- mitment technology that would insure time consistency is required since, by behaving in this way, the government would lose the ability to issue nominal non-state contingent debt, which would in turn require the increased use of taxes and lead to a decrease in welfare. The second important point emerging from this literature is that taxes and government debt inherit the time series properties of the underlying shock.
By contrast, Calvo and Guidotti (1993) and Chari et al.(1991) analyze optimal policy within a similar neoclassical setting but remove the assumption of the availability of state- contingent claims and assume that the government can issue only non-contingent nominal debt. They nd that the optimal tax rate is stable over time, and that it also inherits the properties of the underlying shock. The stability of taxes is obtained via the use of un- expected in ation. In this way, by making nominal claims state contingent in real terms, the need to use taxes to nance current and future debt obligations is reduced. In other words, unanticipated in ation serves as a lump-sum tax on nancial wealth and allows the government to maintain highly stable tax rates over the business cycle.
While this literature can provide useful policy recommendations, the absence of a real macroeconomic rationale for stabilization policies undermines its usefulness for the
1.3 Optimal Monetary and Fiscal Policy and Labour Market Frictions 29
understanding of optimal policy behaviuor over the business cycle. More precisely, the as- sumed neoclassical setting featuring the absence of any kind of nominal or real rigidities is the basic driving mechanism behind some of the results. In other words, costless price adjustment in the Chari et al. (1991) setting allows the policy maker to use in ation to ren- der the real debt state-contingent and thereby keep taxes stable, making in ation volatility and tax stability a feasible and optimal policy.
The second and more recent stream of literature abandons the neoclassical setting and introduces market imperfections and nominal rigidities.13 Thus, the need for macro-
economic stabilization policy emerges. There are two important differences between the two approaches. First, the neoclassical approach environment features distortionary taxa- tion, while this recent approach assumes either implicitly or explicitly that the government has access to the lump-sum taxes to nance its budget. This in turn removes the need for the use of unanticipated in ation, which acts as the lump-sum tax on nancial wealth. Sec- ond, although the modelling environment is characterized by imperfect competition, most of the literature assumes the existence of production or employment subsidies that would eliminate the distortions arising from competition imperfections. Major optimal policy implications are that in ation should be set to zero or close to zero in every state and in all times. The reason behind this result is rather intuitive. Costly price change requires a constant price level to minimize in ationary distortions associated with it. Fiscal con- sequences of shocks play no role in optimal policy determination since the availability of lump-sum taxes can easily deal with them.
13 For a interesting summary of major advances and implication of this approach see Clarida et. al.
The methodological contributions of this literature, which combines the technical rigor of the neoclassical setup with up to now somehow neglected, Keynesian views on imperfect price and wage adjustment, are certainly large. Moreover lessons learned from its policy implications constitute an additional dimension of its importance. Yet many features incorporated in those models are far from being realistic and justi able on other grounds then as the tools generating expositional and technical convenience. Additionally, when compared with the neoclassical literature, this stream of literature provides com- pletely opposite recommendation for the conduct of optimal monetary and scal policy.
As a reaction to the differences in policy implication between those two approaches, the third stream of literature emerges, combining crucial featured of both approaches. Speci cally, the unrealistic assumption of lump-sum tax availability is removed. Thus, the tax instruments at policy maker disposal become distortionary. Moreover, markets for debt are incomplete and the government can issue only one period nominal non-state contin- gent debt. Neoclassical assumptions of perfect competition and exible prices are replaced by monopolistic competition and some form of costly price adjustment. Thereby, Benigno and Woodford (2003) analyze a model in which prices are set in a staggered fashion rst introduced by Calvo (1983), whereas producer's price setting in Schmitt-Grohe and Uribe (2004a,2004b) is subject to convex price adjustment cost proposed by Rotemberg (1983). In this setting optimal policy maker faces trade-off between distortions caused by in ation and tax rate volatility in response to unexpected shocks hitting the economy.
Several important implications arise under this modi ed setting. First, optimal mon- etary policy features price stability even for a small degree of price rigidity. In other words
1.3 Optimal Monetary and Fiscal Policy and Labour Market Frictions 31
when prices are sticky, the aforementioned trade-off is overwhelmingly resolved in favour of price stability. The reason behind this result is again the consequence of costly price setting. Second, when prices do not adjust costlessly, tax and debt do not inherit the time series properties of the underlying shock, but are characterized by a near random walk be- havior. In the opposite case when price are fully exible, but markets are still imperfectly competitive, taxes and debt do inherit the time series properties of the underlying shocks. Thus, the optimal in ation process when prices are sticky is more in line with the second stream of literature, which ignores the scal consequences of monetary policy actions by assuming the availability of a lump-sum tax instrument. However, tax and debt proper- ties are in line with the optimal neoclassical monetary and scal policy literature with real non-state contingent debt as analyzed in Aiyagary et al. (2002).
However, most of the optimal monetary and scal policy literature abstract from any real frictions in the labour market. In other words, regardless of whether the analysis is conducted within the neoclassical setup or within more recent New-Keynesian setup, the labour markets are assumed to be Walrasian. By introducing such an assumption, one is neglecting the short run in ation-unemployment trade-offs arising as a consequence of labour market friction and certainly describing the real world economy. In Chapter 3. we construct the model in New-Keynesian tradition characterized by imperfect competition in the goods markets as well as costly price changes. But we depart from mainstream New- Keynesian literature and replace the Walrasian labour markets with a search-matching mechanism. Additionally, we introduce explicit scal considerations into our analysis,
so far fully neglected in the New-Keynesian models which feature matching characteris- tics of the labour markets.
We follow public nance literature in the spirit of Lucas and Stokey (1983) and solve the constrained Ramsey problem which takes into account all of the constraints char- acterizing competitive equilibrium in addition to all of the wedges inherent in the model economy. Thereby we capture the positive aspects of the effects of search-matching ex- ternalities. We resort to numerical techniques to illustrate the dynamic implications of our setup. Speci cally, we consider the optimal policy responses in cases where the economy is hit either by a positive neutral technological shock or by a positive government spending shock.
We arrive at several important results. First, the increase in the technological level, by leading to an increase in consumption and employment, allows the Ramsey planner to reduce both in ation and the tax rate to fully exploit the bene ts of productivity enhance- ment. This in turn leads to an increase in demand and an increase in rms marginal pro ts, thereby boosting vacancy posting and increasing employment. Thus, the optimal policy is achieved by deviating from strict price stability, which contrasts with standard New- Keynesian predictions. Second, the presence of unemployment bene ts and the expecta- tional dynamic effects of tax rates on wages identify additional channels through which the Ramsey planner can in uence ef ciency. More precisely, by using taxes, the Ramsey planner can directly reduce inef ciencies stemming from the presence of unemployment bene ts as well as the wage, by affecting both current and the expected future tax rates and thereby rms' marginal costs. Third, we nd that the optimal tax rate and optimal real