On (Sub) Optimal Monetary Policy Rules under Untied Fiscal Hands

We examine the interplay between monetary and fiscal policies in a context where disturbances to the public deficit process are a primary source of macroeconomic instability. We perform simulations of optimal targeting rules on a sticky-price model `a la Woodford (1997). Our investigation compares the dynamic adjustment path under inflation targeting with that arising from nominal income growth targeting. When fiscal shocks enter the picture, inflation targeting is a superior strategy. In opposition to Jensen (2002)’s results, we show that an inflation targeter is capable of bringing about the required degree of interest rate inertia. This does not occur at the cost of additional nominal instability.