Tax smoothing and optimal inflation persistence in RBC monetary models revisited
| Published date | 01 November 2022 |
| Author | Mehrab Kiarsi |
| Date | 01 November 2022 |
| DOI | http://doi.org/10.1111/sjpe.12311 |
Scott J Polit Econ . 2022;69:465–486. wileyonlinelibrary.com/journal/sjpe
|
465
© 2022 Scottis h Economic Societ y
Received: 16 Augu st 2020
|
Accepted: 7 Januar y 2022
DOI: 10 .1111/sjpe.1 2311
ORIGINAL ARTICLE
Tax smoothing and optimal inflation persistence in
RBC monetary models revisited
Mehrab Kiarsi
School of Econo mics, Henan Unive rsity,
Kaifeng, China
Correspondence
Mehrab Kiarsi, School of Economics, Henan
University, Kaifeng, China.
Email: mkiarsi@gmail.com
Abstract
This article re- examines the optimality of tax smo othing
and optimal inflation p ersistence in the contex t of mon-
etary model s with cash constra ints where the Friedm an
rule is not optimal. I consi der distortiona ry taxes on either
consumption or labor in come. As a consequen ce of the
non- optimality of the Frie dman rule, the Rams ey- optimal
policy features a t ax rate volatility that is orders of magni-
tude larger than th e cornerstone ta x- smoothing result of
the standard R amsey literature. The R amsey results also
imply an optimal inflat ion rate that is much more persistent
than the existing r esults. When all con sumption goods are
subject to a cash cons traint, purpos eful tax and interes t
rate volatilities are use d to smooth wedges. The refore, in
contrast to the wide ly accepted view in the liter ature that
in RBC models wedge smo othing implies tax sm oothing,
this paper shows that t his is not necessarily true. I also dis-
cuss the Ramsey probl em in the context of the cash- cre dit
goods framework with non- homothetic preferences where
neither tax- sm oothing nor wedge smooth ing result neces-
sarily holds when t he Friedman rule ceases to be optimal.
KEYWORDS
flexible price s, optimal tax volatilit y, perfect competiti on, tax
smoothing, the Friedman rule
JEL CLASSIFICATION
E52; E61; E63
466
|
KIARS I
1 | INTRODUCTION
The optimalit y of tax smoothing is a key polic y implication of the public f inance literature. It is als o a key result in
the existing li terature on the joint determinat ion of optimal fiscal and monet ary policy in flexible- price environ-
ments with pe rfect compe tition in produc t and factor markets. In a semi nal paper, Chari et al. (19 91) solve the
Ramsey proble m for optimal monetary and fiscal policy in the s tochastic version of the Lu cas and Stockey (1983)
cash and credit go ods model, where the government c an issue only nominal non- state- conti ngent bonds. Cha ri
et al. (1991) show t hat in their model, income t ax rate is remarkably sta ble and inflation is highly volat ile and dis-
plays a near- zero s erial correlation over tim e. Benigno and Woodford (2003), S chmitt- Gro hé and Uribe (2004b,c),
and Siu (2004) also f ind the same results i n stochastic environme nts with perfect co mpetition and flexibl e prices.
The key reason behi nd these results is the optima lity of the Friedman rule, name ly the optimality of setting t he
nominal interes t rate at zero at all dates and all state s of the world. Due to this optimalit y, the tax rate emerges
as the sole distor tion in those m odels, and the refore, it is optima l to keep it constant ove r the business c ycle.
Moreover, with the opti mality of an all time- ze ro nominal interest rate, the i nflation rate becomes seria lly uncor-
related and has an al most zero first- order autocorrel ation.
It is importa nt to note that in the ab ove- mentione d literature (Be nigno and Woodford (20 03), Schmitt-
Grohé and Urib e (2004c), and Siu (2004)), even when pr ices are sticky and the Fried man rule is not optimal,
still the optim al inflation per sistence is near zer o. The reason is the o ptimality of th e Friedman rule in th e
first place un der flexible pr ices and perf ect competit ion. In moving to the s ticky price e nvironments , the
Ramsey planner faces a tension between minimizing the opportunity cost of holding money and minimizing
the price adjus tments cost. While the Fri edman rule versus stick y- price tradeof f is resolved in favor of price
stability a nd the optimal r ate of inflation is near ze ro, however, the optimal inf lation persis tence remains
approximately zero.
This paper shows t hat this benchma rk tax smooth ing policy pres cription and a ne ar- zero optimal inflati on
persistence d o not carry over to a cash con straint monetar y model where it is the comp osite consumption good
that is subject to a c ash constraint, or to the cash - credit goods model whe re the utility function is not h omo-
thetic. First, following Schmitt- Grohé and Uribe (2000, 2007), I consider a cash co nstraint monetar y framework
where househo lds’ aggregate co nsumption expe nditures are sub ject to a cash cons traint. In st udying optimal
fiscal and mon etary poli cy with a cash cons traint, it is more common in the rel ated literature to co nsider the
cash- cr edit good model of Lucas and Stockey (198 3), where, d ue to some restri ctive assumptions imposed on
preferences to be come homothet ic, the Friedman r ule in the presen ce of distortion ary taxes is op timal1 (see,
e.g., Chari et al . (1991); Siu (2004); Chugh (20 06, 2007); C orreia et al. (2008); and C anzoneri et al. (2010) among
many others). In this f ramework, the Friedman rule in t he presence of market power, without or wi th nominal
rigidities, ce ases to be optimal. However, so long a s preferences are homoth etic, the Ramsey- optimal policy still
continues to feat ure an inflation ra te with no serial cor relation, and an optimal tax vol atility that is qu ite low,
which is specif ically the case with only im perfect competition a nd no price stickiness (see, e .g., Siu (2004) and
Chugh (2006, 2007 )).2
However, the results tu rn out to be quite differe nt when we study optimal f iscal and monetar y policy where it
is the composite goo d that is subject to a cash constr aint. That is, the re is no distinction betwee n consumption
1This is not, howe ver, the case in the re lated import ant works of Step hanie Schmitt- Grohe and Mar tin Uribe where t hey either cons ider a
transact ion cost model o r a cash constra int model where t here is no disti nction betw een consumptio n goods, as is the c ase in the prese nt paper
(see, Schmit t- Grohé and Uri be (2000, 2004b,c, 2005a,b, 2007, 2012)).
2The same resu lts also hold in o ther monetar y framework s that feature t he optimality o f the Friedman ru le under perf ect competit ion and flexibl e
prices (e.g. , Schmitt- Grohé and Uribe (2004b,c) a nd Benigno and Wo odford (2003)).
Get this document and AI-powered insights with a free trial of vLex and Vincent AI
Get Started for FreeStart Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
