Essays on monetary and fiscal policy

The optimality of monetary policy rules has been examined extensively in the macroeconomic literature. This dissertation consists of two studies that build on previous work in this field. Each study examines the optimality of monetary policy through different settings and with different objectives. The first study, which is presented in chapter II of this dissertation, examines the optimality of monetary policy rule in the presence of fiscal policy shocks. It considers three monetary policy rules: a strong response to inflation, a response to inflation and unemployment and a standard Taylor rules, following shocks to government expenditure, labor-income tax rate and consumption tax rate. It shows that, when the objective is stability in macroeconomic aggregate variables, following shocks to the consumption tax rate and government expenditures, monetary policy maker should target inflation and unemployment rather than follow a Taylor rule that responds to output alongside inflation. However, following a labor-income tax rate shock, strong response to inflation outperforms other rules, while response to inflation and unemployment is preferred over a standard Taylor rule. The welfare exercise in the first study shows that strong response to inflation still outperforms other rules regardless of the source of shock to the economy. The second study, which is presented in chapter III of this work, examines the interaction between Basel minimum capital requirements, monetary policy and real economic aggregates while checking for the suitability of nominal GDP (NGDP) targeting versus inflation rate targeting rules. The study combines the two concepts. In particular, it examines the effect of negative supply-side and demand-side shocks on real economic variables while including a counter-cyclical component to the capital adequacy requirement conditions and applying nominal GDP targeting and inflation-targeting monetary policy rules. The second study shows that, under NGDP targeting, the capital requirement condition becomes a function of the inflation rate as opposed to the real output gap. While both shocks have the same impact on real output, their implications for inflation differ, thus potentially calling for reducing capital requirements in downturns, which contradicts the intention of the capital requirement rule. This result suggests that diagnosing the source of the shock is important before prescribing the remedy. In addition, the study shows that while the inflation-targeting rule leads to more stability in macroeconomic aggregates, it induces greater welfare losses than nominal GDP-targeting rules.