Optimal Fiscal and Monetary Policy when Money is Essential

S. Boragan Aruoba and Sanjay K. Chugh, Journal of Economic Theory 145(5), 1618-1647, September .


We study optimal fiscal and monetary policy in an environment where explicit frictions give rise to valued money, making money essential in the sense that it expands the set of feasible trades. The two main results are that the Friedman Rule is typically not optimal, and the long-run capital income tax is not zero. Neither of these results is due to any incompleteness of the tax system, as can sometimes occur in standard Ramsey analysis. Rather, by developing a precise notion of margins of adjustment using standard concepts of MRS and MRT, we show that the tax system in our model is complete. The need to distort cash-intensive activity in some sense causes a nonzero capital tax in our model. This deep connection between monetary issues and fiscal policy is in contrast to existing models of jointly-optimal fiscal and monetary policy, in which the monetary aspects of the economic environment have little to do with capital taxation prescriptions. Taken together, these findings reframe some conventional wisdom from baseline Ramsey models.

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