Optimal Interest Rates Under Endogenous Fiscal Policy

Mercedes Haga
Ponticia Universidad Catlica de Chile
March 17, 2009
Abstract
It is a fact that some politicians once they reach the power do not behave as benev-
olent planners but as self-interested bureaucrats, according to which, they make scal
decisions. On the other hand, central bank independence claims that the monetary
authority should set its control variable only in accordance to its loss function. This
paper studies wether this is still true in an environment where scal expenditure is
endogenously determined by a self-interested incumbent whose scal decisions might
be contrary to individuals welfare. I nd that the central bank should always care
about the way the scal authority sets its consumption path as a signaling eect. Fur-
thermore, the larger is the government relative to the private sector, the more sensitive
the central banks reaction should be. I also nd microfoundations for forward-looking
Taylor rules. Finally, even if the government would also be concerned with individuals
welfare; the central bank should still consider deviations of scal expenditure in its
reaction function.
1 Introduction
It is a fact that some politicians once they reach the power do not behave as benevolent
planners but as self-interested bureaucrats (sometimes with non-social objectives such as
personal enrichment or re-election), according to which, they make decisions. One of those
decisions is to specify scal expenditure. Fiscal expenditure has a high social impact
not only because of its direct eect on welfare, but also because it inuences the price
level determination and therefore ination. However, current general equilibrium models
do not account for this feature and consider scal choices as an exogenous process. On
the other hand, agency models do deal with political economy issues, but they are all
1
partial equilibrium models. In this way, many interactions between variables might not be
considered not only in general equilibrium models but also in partial equilibrium ones; for
example, how should the monetary authority react in the presence of a scal shock when
the incumbent cares only about its own welfare? How will households allocate consumption
and labor when they know that the government is not interested in soften shocks for them?
Will rms also behave in a dierent way? And more importantly, what can we expect from
the interaction between a self-interested scal authority and a central bank concerned with
consumerss welfare? In other words, what is gained in terms of interaction between scal
and monetary authorities when one of them behaves in a selsh way?
By the end of 2008 a group of twenty eight developed and developing countries have
adopted ination targeting regimes as a way to conduct their monetary policy.
1
The rst
one to do it was New Zealand in 1990 while the last one was Ghana in May, 2007. It is
interesting to notice that even though countries are very dierent from each other as long as
their macro variables are concerned (for example current ination, interest rates, GDP per
capita, etc.), all targets uctuate between 0/ and /.
2
In this way; and precisely due to
their dierence in macro fundamentals, it is not expected for example, for the Reserve Bank
of Australia to react in the same way as the Central Bank of Chile or the Central Bank
of Peru whenever a shock occurs. Considering target interest rate, scal expenditure and
ination data for these three countries I nd that the percentage change of the interest rate
to a 1/ change in scal expenditure is not statistically signicant in the case of Australia,
but equals 0.0 for Peru and 2.024 for Chile (regressions are shown in the appendix). This
tells us that there are some considerations underlying that makes central banks to behave
dierently in each country.
Keeping the previous discussion in mind, this paper investigates how political economy
aects the structure and dynamics of consumption, labor, ination and how do optimal
interest rate rules change when it is present the interaction between a self-interested in-
cumbent and a "benevolent" and independent central bank that wants to minimize its loss
function. For that, I use a closed-economy general equilibrium model to address the con-
ict of interest that arrises between voters and rent-seeking politicians who like to consume
for their own purposes the same type of goods as households. This approach will allow
us to obtain a general equilibrium model able to describe the behavior and interaction
1
Finland and Spain however, have abandoned the regime in 1999 when they joined the European Eco-
nomic and Monetary Union.
2
Exceptions are Indonesia and Ghana with targets of 6%(1%) and 0 10% respectively.
2
of all variables (for example, the behavior of ination, not present in partial equilibrium
models), and at the same time incorporate distortions in scal expenditure manipulation
arising from political economy; all of which has a direct impact on ination and therefore
on the central banks best response to this environment. It is important to note that the
intitutionality underlying this model is such that even though it can not prevent the incum-
bent from taking over a portion of total scal expenditure, it does guarantee the central
banks independence; that is to say, the government can not pressure the central bank to
deviate from its loss function.
This work is related to two dierent literatures: political economy and optimal targeting
rule. As long as political economy is concerned, this work is placed within "opportunistic-
rent-seeking" politicians models in line with Diermeier, Keane and Merlo [2005], Shi and
Svensson [2006] and Acemoglu, Golosov and Tsyvinski [2008] where re-election is pursued
for politicianss own welfare in terms of expected returns of being in power (i.e. ego rents
or self-enrichment). I will assume politicians want to hold oce because it enables them
to appropriate from a certain fraction of public expenditure for their own consumption.
On the other hand, the optimal targeting rule part of this paper is most closely related
to Clarida, Gal and Gertlers seminal contribution on the eld as I will analyze dierent
interest rate rules for monetary policy that come from the interest (or command) of the
central bank in minimizing a quadratic loss function.
3
In particular, I will work with the
hybrid neokeynesian Phillips curve proposed by Gal and Gertler [1999] in order to capture
ination persistence that seems to characterize the data.
4
In this way the model is derived by the interaction between a self-interested incumbent
concerned with holding oce and an independent central bank concerned with households
welfare. I study a monopolistic competitive closed economy with no capital and scal
shocks, equivalent to the framework used in Walsh [2003]. To capture the fact that politi-
cianss incentives are not always aligned with the citizenss ones, I will assume that the
policymaker would like to manipulate scal expenditure in a selsh way. In other words, the
incumbent will be willing to mislead the voters perception about his competence through
scal expenditure and have a higher probability of reappointment, as implied by Shi and
Svenssons [2006] work.
I nd that not only for the case with no government but also for the case where scal
expenditure is exogenously determined, the monetary authority should set the interest
3
Woodford [2003] show that this is consistent with the maximization of the consumers welfare.
4
See for example Henzel and Wollmershaeuser [2006] for a recent discussion.
3
rate considering deviations of expected ination with respect to its steady state level and
current and expected output gap. On the other hand, if scal expenditure is determined
by a self-interested incumbent, the central bank should react not only to expected ination
but also to scal deviations with respect to its steady state value. This is because even
in the case where the government is considered, if scal expenditure is exogenously given,
the central bank can do nothing to change this level; but this is not true if the incumbent
endogenously decide it. In this sense, changes in the interest rate when deviations of scal
expenditure around its steady state level occur, acts as a signal to the government which
reminds him how committed to ination the central bank is and looks forward to discourage
him from high expenditures levels by raising the interest rate. This signalling eect is, in
fact, bigger the bigger the public sector is relative to the private sector.
The paper is organized as follows. Section 2 briey summarizes the literature related
to this work. Section 3 describes the basic model. Section 4 solves it for the benchmark
case of no government, for the case of a government with an exogenous expenditure path
and for the case of a self-interested incumbent (all of them considering an independent
central bank ). Section 5 shows the impulse response functions to a one percent scal
shock and section 6 extends the model for the case when not only the central bank but
also the government is concerned with individuals welfare. Finally section 7 concludes.
An appendix shows the estimated regressions and proves the main equations.
2 Related Literature
Two motivations are put forward in the political economy literature to capture politi-
cians incentives to move away from a benevolent behavior. On one hand, they might
be "ideologically-motivated" and in this way only care about the well-being of particular
groups of society; which means that they will choose policies in order to maximize a social
welfare function that puts a disproportionate weight on these groups. These are known
as partisan politicians. On the other hand, politicians can act in a purely self-interested
way if they choose policies as to hold oce because of its value per se; or because holding
oce allows them to extract tangible rents. These are known as opportunistic politicians,
and to be more precise, those who want to hold oce per se are called "oce-seeking",
while those who also want to extract tangible rents are called "rent-seeking". As it was
said before, I shall focus on "opportunistic-rent-seeking" politicians in line with the ones
present in Diermeier, Keane and Merlo [2005], Shi and Svensson [2006] and Acemoglu,
4
Golosov and Tsyvinski [2007]. Next I will briey discuss these papers along with Clarida,
Gal and Gertler [1999].
Diermeier, Keane and Merlo [2005] want to explore motivations and objectives of elected
politicians in a context of political career in order to quantify the returns of a United States
Congress career. For this, they use the idea that politicians are forward-looking rational
individuals that make decisions over their career taking into account the expected returns
of dierent choices; and they also count on novel data base with information about post-
congressional employment of former members of Congress and their wages. In this way,
politicians might be interested in choosing a congressional career not only because of the
utility of being in oce, but also because of its monetary returns. Their key innovation is
that they explicitly model career opportunities of politicians outside Congress when they
leave it: they can choose between a job in the private sector or in the public sector. Their
salary depends on their age, education, number of terms in oce committee assignments
and weather their exit was voluntary or due to electoral defeat. At the same time, politi-
cians can dier in their personal characteristics that may aect not only elections outcome
but also their wage out of Congress. In this way, the authors propose a dynamic problem
in which a Congress member must decide weather to run for re-election, run for a higher
oce or exit from Congress (either to work in the public or private sector or to retire)
every two years. To solve this problem, they assume there is a "minimum age" and a
"terminal" age to be a congressman (thirty and eighty years respectively); then by posing
the determinants of post-congressional payos, senators decisions, representatives deci-
sions, re-election probabilities and the evolution of exogenous state variables, they solve it
backwards. Their main results are the following: Congress experience has a positive and
signicant eect on post-congressional wages (in both, the public and the private sector);
second, non-pecuniary earnings from being in congress are as considerable as monetary ones
(in fact, monetary earnings alone are not enough to explain politicians behavior); third,
non obsevable skills like charisma helps politicians to increase their re-election probability,
but does not help them to get a higher wage out of Congress; fourth, there is no evidence of
selectivity bias about who runs for re-election but the contrary happens when a politician
must run for a higher oce; nally, to impose a limit for terms would rise signicantly
"voluntary exits", biased towards who have better political skills and the older.
Shi and Svensson [2006] contribute to the empirical cross-country literature on political
budget cycles and formulate a model that accounts for the evidence of the existence of
political budget cycles and their systematic dierences between developing and developed
5
countries. In a partial equilibrium model they focus on the incumbents optimizing behav-
ior, where they assume that the government likes to consume the same type of goods as
households; but its consumption path will be conditioned to being reelected. To achieve
this, the incumbent manipulates public expenditure in order to confuse uninformed voters
who can not see clearly weather a higher expenditure level means policy manipulation or
governments competence (that is to say, they work with a political career model). They
nd that, rst of all, the governments budget balance is inuenced by the timing of the
elections: prior to elections politicians have incentives to expand expenditure in order to
increase his re-election probability; which in turn will be stronger if there are high rents
from being in power and if there is a bigger portion of uninformed voters. This is very
intuitive as greater rents from being in power will make incumbents be willing to hold oce
no matter what and on the other hand, if by manipulating expenditure the incumbent can
mislead a greater share of voters, he will have incentives to do so; higher rents and higher
portions of uninformed voters are expected to be consistent with less developed countries.
In this way, the authors can account for the mentioned dierence in political budget cycles
between developed and less developed countries.
Acemoglu, Golosov and Tsyvinski [2008] study optimal taxation also in a context where
the system is not operated by a benevolent planner but by a rent-seeking self-interested
politician. Political economy environment though, is dierent from the present paper as
they deal with an electoral accountability model; that is, politicians have complete discre-
tion once in oce, but voters can oust them from oce at the next elections; so voters
act retrospectively and deliberately punish bad behavior by replacing the bad government.
Their main contribution is to introduce political economy to a dynamic Mirrlees problem
and in that way, give conditions under which political economy distortions persist or dis-
appear in the long run. In particular, optimal tax structure will be the same as in the case
with no political economy distortions if politicians are as patient as individuals; otherwise
aggregate taxes on labor and income will persist even in the long run. To design the best
mechanism that might best avoid the distortions created by the presence of this type of
politicians and lack of commitment, contrary to this paper, they only need a partial equi-
librium model that species individual preferences and game present between the selsh
politician and the executioner voters to obtain the subgame perfect equilibrium path for
taxes.
On the other hand, the other pillar of this paper and what makes it original is the
interaction of this self-interested government with the central bank. For this, I will rest on
6
the New Keynesian perspective of monetary policy pioneered by Clarida, Gal and Gertler
[1999]. In their paper they obtain the optimal monetary policy stressing the existence of
nominal rigidities and also incorporating micro-founded bases to their model. In this way,
they analyze the cases of a discretionary and a committed central bank that minimizes an
ination and output gap quadratic loss function taking into account the demand side of
the economy given by consumers optimal behavior and the supply side of the economy,
given by the rms optimal behavior. These cases allow them to show the gains from
commitment: it eliminates the inationary bias in the case the central banks target for
real output exceeds the market clearing level and more importantly, if the central bank
is to credibly ght ination in the future, commitment improves output-ination trade
o faced by the central bank. Even though it is not the aim of this paper to see the
gains of rules versus discretion (in fact, I will consider a committed central bank that can,
through this, aect ination and output expectations); it will be useful for the present
work to make the central bank behave in the same way as theirs. Moreover, within the
New Keynesian perspective, I will use the hybrid concept of the Phillips curve proposed
by Gal and Gertler [1999]. To capture the ination inertia that seems to characterize US
ination time series, the authors set out a model with nominal rigidities and a fraction of
rms that set their prices not by maximizing the present value of future expected prots,
but by a backward-looking rule. They empirically test the dynamics of ination for US
data for the period 1960 - 1997 and use labor income share in the non-farm business sector
to approximate real marginal cost instead of using output gap. They actually nd that
"backwardness" though statistically signicant, it was of no quantitative importance and
so, the New Keynesian Phillips curve gives a good approximation to US ination dynamics.
They nally claim that this may be so because the source of ination inertia might be the
sluggish adjustment in real marginal costs and not backward-looking rms. Some authors
however, argue that this result is only due to estimation methods used in the paper.
5
3 The Model
I will use the moral hazard model proposed by Shi and Svensson [2006] and put it to work
on a standard cashless neokeynesian general equilibrium model as the one used in Walsh
5
See Rudd and Whelan [2005] and Lind [2005] for a more recent discussion and Gal, Gertler and
Lpez-Salido [2005] for an answer to it.
7
[2003].
6
In this way I will be able to derive an expression for the ination rate consistent
with an optimizing policymaker.
In this model there are four types of agents: households, rms, politicians and a central
bank. This section describes the decision problem for each of them.
3.1 Households
There is a continuum of innitely lived agents who drive utility from consumption and
leisure. Consumption is provided either by the public sector in a proportion c of total
governments expenditure, or by the private sector. Individuals have the same preferences
over the public good, the composite consumption good and labor. However, they dier
over idiosyncratic preferences concerning candidates other policies (besides scal ones).
These idiosyncratic preferences are captured by the parameter 0
c
assumed to be uniformly
distributed on
_

1
2
,
1
2

. Government is in charge of any of the two existing political parties,

a or /;
t
is a binary variable that equals 1,2 if party a is elected and equals 1,2 if /
is elected. Preferences are concave in public and private consumption and in labor; in
particular, I assume this concave function is isoelastic and additive in its arguments (this
assumption has no impact on the results and greatly simplies the mathematics). The
instantaneous utility function for consumers is then:
l
c
(t) =
(cG
t
)
1o
1 o

C
1o
t
1 o

_
1
0

1+j
)t
d,
1 j
0
c

t
where G
t
is the level of a Dixit-Stiglitz aggregate of public good; C
t
is also a Dixit-Stiglitz
aggregate of private consumption of each of the continuum of dierentiated goods c
)t
,
C
t
= [
_
1
0
c
1

)t
d,[

1
with 1 the price elasticity of individual goods and o is the intertemporal elasticity of
substitution of the composite good.
)t
is the labor supply of the representative agent to
sector ,, for which she receives n
t
and j is the corresponding elasticity.
7
Households are the owners of the rms for which they receive prots H
t
and hold
6
As Cochrane [1998] shows, provided the Fiscal Theory of the Price Level, cash can be deleted and
the price level still determined, if the government accepts maturating government bonds directly for tax
liabilities or electronically convert them in dollars for a "nanosecond" before accepting them.
7
Note that nI = nI 8), this means perfect labor mobility among sectors.
8
one-period riskless nominal bonds issued by the central bank, 1
t
, which pay the nominal
interest rate i
t
. Finally, let , be the private sector discount factor and 1
t
the general price
level in period t; so, the consumer problem for citizen : is given by:
max
CI,.I,1I
1
t
1

i=0
,
i
[
(cG
t+i
)
1o
1 o

C
1o
t+i
1 o

_
1
0

1+j
)t+i
d,
1 j
0
c

t+i
[
:.t : C
t

1
t
1
t
=
n
t
_
1
0

)t
d,
1
t
(1 i
t1
)
1
t1
1
t
H
t
(1)
3.2 Firms
There is also a continuum of prot-maximizing rms of measure one that operate under
monopolistic competition; so, they face their demand curve that will be given by FOC of
the consumers problem. The technology available is a CRS function with no capital and
a productivity shock 7
t
. The only thing that distinguishes one rm from another (besides
its output) is that they adjust their prices in dierent dates. In this way, output , is of the
form:
j
)t
= 7
t

)t
; 7
t
~ iid
_
1, o
2
Z
_
and aggregate output is dened as:
1
t
=
_
1
0
j
)t
1
t
j
)t
d,
where j
)t
is the price set for good , in period t. Prices are staggered la Calvo (1983); every
period, only a fraction 1. of all rms adjust prices. Ination persistence is introduced by
a fraction (1 O) of adjusting rms that set prices in a forward-looking way such that they
maximize the expected discounted value of current and future prots; and the remaining
fraction O set prices in a backward-looking way. Let j

)t
be the optimal price set by all
adjusting rms that produce variety ,; ination persistence comes from assuming that:
j

)t
= (1 O) j
)c
)t
Oj
bo
)t
(2)
where j
)c
)t
is the price set by a forward-looking rm and j
bo
)t
is the price set by a backward-
looking rm. Lastly, let t
t
be the income tax rate paid the rms.
9
To solve the pricing decision, a forward-looking rm will choose j
)c
)t
to maximize
1
t
1

i=0
.
i
^
i,t+i
[(
j
)c
)t
1
t+i
)j
),t+i
(1 t
t+i
) c
t+i
j
),t+i
[
where .
i
is the probability of not adjusting price between t and ti; ^
i,t+i
is the subjective
discount factor; as households own rms, this discount factor is related to marginal utility
of private consumption and due to the utility form it equals ,
i
(C
t+i
,C
t
)
o
.
8
Lastly, c
t
is the rms real marginal cost, which is obtained from the cost minimization problem
faced by the rm and equals
&I1I
ZI
. On the other hand, I will use a very simple rule for
backward-looking rms. In fact, I will assume backward-looking rms set their price equal
to the optimal price set by adjusting rms the period before; i.e.:
j
bo
)t
= j

)t1
(3)
It is worth noting that even though this very simple rule says that backward-looking rms
are completely short-sighted, they are actually incorporating information about future
expectations as j

)t1
has a forward-looking part, j
)c
)t1
. So, backward-looking rms are
somehow naive, but not so much.
3.3 Government
Regardless from the ruling party, let q
)t
be the level of good , consumed by the govern-
ment in period t. Therefore, the level of composite public good G
t
(assumed to have the
same elasticity of individuals goods as households), is G
t
= [
_
1
0
q
1

)t
d,[

1
. G
t
will be
exogenously given or endogenously obtained by solving a utility maximization problem
for a self-interested incumbent. Nevertheless, in both cases this level is, in every period,
constrained by tax revenues and a scal shock -
t
. The scal shock can be associated to,
for example, natural catastrophes and comes to be public information at the end of every
period. So, the government budget constraint can be expressed as:
G
t
= t
t
1
t
-
t
; -
t
~ iid
_
0, o
2
.
_
(4)
8
In general, the stochastic discount factor between t and t + 1 equals ,
u
0
(c
t+1
)
u
0
(c
t
)
.
10
3.4 Central Bank
Smoothing policies are in charge of an independent central bank that is not exclusively
concerned about stabilizing ination but also with the stability of the real economy. In
this way, the central bank acts with commitment and sets the nominal interest rate as
to minimize a quadratic intertemporal loss function, considering the eect of changes in
the interest rate on ination through its impact on private consumption and tax rates.
The central bank dislikes high ination,
t
and high levels of output gap r
t
(which has an
exogenous relative weight `), these targets are derived from an optimal policy problem that
wants to maximize a welfare measure given by the expected utility function of households.
9
The central banks loss function is then:
1
t
1

i=0
,
i
(
1
2

2
t+i

`
2
r
2
t+i
)
It is important to note two things: rst, that because of the non existence of capital in
this economy, a central bank is needed so that the equilibrium interest rate is determined
and second, the central bank when it sales bonds, it collects goods, pays its previous debt
and throws away any possible excess.
3.5 Equilibrium
The previous description of all agentss behavior, yield to the following equilibrium deni-
tion:
Denition 1 An equilibrium in this economy is a sequence
_
C
t
, G
t
,
t
, 1
t
, 1
t
, j

)t
, 1
t
,
t
, n
t
, t
t
, i
t
_
1
t=0
such that:
Consumers maximize expected utility,
Firms maximize prots,
Aggregate price level is a weighted average of individual prices and last periods
aggregate price level,
The government maximizes its expected utility;
9
For a formal derivation, see Benigno and Woodford [2003] or Woodford [2003], chapter. 4.
11
The central bank minimizes its loss function and
Markets clear.
4 Solving the Model
The timing of the events is as follows: rst, the central bank minimizes its loss function
by choosing the nominal interest rate, then the government (in the case of a self-interested
one) sets its expected consumption level and, as a residual from its budget constraint, the
tax rate needed to get a balanced budget. At this point is important to emphasize that the
government does not issue public debt and so, it does not aect the economys interest rate
through this channel (I made this assumption because with no default probability, this type
of bonds should be a perfect substitute of the ones issued by the central bank; this only
adds noise to my model and has no implications for the core of the paper). The third player
in this sequential game are rms which decide the optimal price level from which ination
can be obtained. Finally, consumers determine their optimal levels of private consumption,
labor and bond holdings. Solving backwards, I rst present consumers utility maximization
subject to their budget constraint, which will give us the private side of aggregate demand
curve; then rms maximize prots subject to consumers optimal choice and in this way
I obtain the aggregate supply curve; the Hybrid New Keynesian Phillips Curve. Thirdly,
the government solves its problem which will be trivial if scal expenditure is considered as
an exogenous process and will be microfounded for the case of a self-interested incumbent.
In the later case, the government will maximize its own utility subject to the re-election
probability and the behavior of rms and households. Finally, the central bank solves its
problem subject to the demand and the supply side of the economy (the demand side will
consider scal behavior, whether it is exogenous or endogenous).
4.1 Benchmark Case: No Government
4.1.1 Households
As mentioned, I will start by solving the households problem. Like in standard procedures,
I divide the problem in two parts:
(a) First choose the optimal combination of individual goods that minimize the cost of
purchasing a certain level of composite good, given its denition. From the FOC, I
12
obtain individual demands and an expression for the aggregate price level:
c
)t
= C
t
(
j
)t
1
t
)

(5)
1
t
= [
_
1
0
j
1
)t
d,[
1
1
(6)
(b) Then, using () and (6) to solve (1), the Euler condition for the optimal intertemporal
private consumption, labor and the transversality condition are:
C
o
t
= ,(1 i
t
)1
t
1
t
1
t+1
C
o
t+1
(7)

j
)t
C
o
t
=
n
t
1
t
(8)
lim
T!1
1
T
1
T
= 0 (9)
where 1
T
=
T

)=0
1
(1+i
I+
)
.
4.1.2 Firms
To solve the forward-looking rms problem, rst note that in equilibrium it must be true
that j
)t
= c
)t
; where c
)t
is given by () so that j
),t+i
= (
j
I
1
I+.
)

C
t+i
. Forward-looking
rms problem is:
max
j
]o
I
1
t
1

i=0
.
i
^
i,t+i
[(
j
)c
)t
1
t+i
)
1
c
t+i
(
j
)c
)t
1
t+i
)

[C
t+i
The FOC, the fact that ^
i,t+i
, due to the utility form, equals ,
i
(C
t+i
,C
t
)
o
and the
symmetry between rms, imply that the optimal price satisfy:
j
)c
t
1
t
=

1
1
t

1
i=0
.
i
,
i
C
1o
t+i
c
t+i
(
1
I+.
1I
)

1
t

1
i=0
.
i
,
i
C
1o
t+i
(
1
I+.
1I
)
1
(10)
This is the familiar result in which the price of a forward-looking rm is a markup
(

1
1) over the rms real marginal cost. Equation (10) shows how adjusting rms
set their price, conditional on current aggregate level 1
t
. This aggregate price index is an
average of the price charged by the fraction 1 . of rms setting their price in t and the
13
remaining fraction . of all rms that set their price in earlier periods. To obtain 1
t
, from
(6) it can be shown that the average price in period t satises
10
1
1
t
= (1 .)(j

t
)
1
.1
1
t1
(11)
where j

t
is dened in equation (8) .
Let

/
t
denote the percentage change of a variable 1
t
around its steady state level 1. I
also assume that the steady state involves a zero ination rate, then (10) can be linearized
around the steady state to obtain aggregate ination as:

t
= A
2
1
t

t+1
A
3

t1
A
4

c
t
(12)
where the coecients A: are dened in the appendix, are all positive and for the special case
of pure forward-looking rms scenario, it is true that A
2
= ,; A
3
= 0 and A
4
=
1.
.
(1 ,.)
as in the traditional New Keynesian Phillips curve. Equation (12) is known as the Hybrid
New Keynesian Phillips Curve (HNKPC). Here, ination is forward-looking, it also has an
inertial component and real marginal cost is a very important determinant of the ination
rate. As standard results, ination rate does not directly depend on output gap, but it can
re related to deviations of real marginal cost; in fact, deviations of real marginal cost can
be expressed as:

c
t
= (j o) ( j
t
j
)
t
)
where the superscript ) denotes the exible price equilibrium (i.e. . = 0).
4.1.3 Central Bank
The central bank will minimize its loss function subject to the demand and supply side of
the economy. Let r
t
= j
t
j
)
t
be the output gap with respect to the exible price case;
linealization of the Euler equation results in the demand side, or the 1o curve, whereas
the supply side is given by the HNKPC. In accordance with its steady state level, it was
assumed that the central bank has a zero ination target. The central banks problem is
10
See Walsh [2003], chapter 5.
14
presented as follows:
min

I+.
,a
I+.
,i
I+.
1
t
1

i=0
,
i
(
1
2

2
t+i

`
2
r
2
t+i
)
:t :
r
t
= 1
t
r
t+1

1
o
1
t

t+1

,i
o

i
t
n
t

t
= A
2
1
t

t+1
A
3

t1
A
4
(j o) r
t
where n
t
= 1
t
j
)
t+1
1
t
j
)
t
is an exogenous disturbance. I will divide the problem in
two stages: rst, minimize the loss function subject to the ination equation considering
that, because of commitment, the central bank can eectively aect output and ination
expectations. Then, conditional on the optimal values of r
t
and
t
, nd the value of i
t
implied by the demand curve.
11
The FOC of this problem entails the following dynamics
for the output gap:
r
t
1
t
r
t+1
=
A
4
(j o)
`
1
t

t+1
,A
3
1
t
r
t+2

_
1
1
,
A
2
_
r
t
The optimal policy rule for the interest rate that emerges from the demand side is then:

i
t
=
1
,i
_
1
oA
4
(j o)
`
_
1
t

t+1

o
i
A
3
1
t
r
t+2

o
,i
_
1
1
,
A
2
_
r
t

o
,i
n
t
(13)
So, from equation (18) we can see that interest rate will depend exclusively on expected
ination and, because of the existence of backward-looking rms, on actual and expected
output gap. Higher expected output gap will make the central bank to rise the interest rate
as expected and higher deviations of output today will also imply a higher interest rate for
a suciently low degree of stickiness (i.e. for a suciently high value of the probability
.). On the other hand, the central banks reaction to a higher expected ination rate
depends on the portion of rms adjusting prices through the parameter A
4
, on labor and
consumption elasticities and on the exogenous relative weigh for the output gap `. If
there is a higher fraction of rms adjusting prices, output gap will be lower ( as can be
seen in the appendix, A
4
is an increasing function of the fraction of rms adjusting prices)
and the central bank will not have to tighten so hard the interest rate if there is a rise
in the expected ination rate. The same eect will have a higher labor and consumption
11
This is because the demand side is not an active restriction in this problem.
15
elasticities. A higher sensibility of labor supply makes the output gap be lower due to
the eect of hours worked on consumption through the individuals budget constraint.
Meanwhile, higher intertemporal elasticity of substitution o means consumers can easily
transfer consumption to the future or vice versa, implying small changes in policy have
big eects on this variable and therefore on output gap. It is also true that if the output
gap has a high weigh ` in the central banks loss function, the monetary authority will
be willing to react largely to changes in the expected ination rate as this variable has an
indirect eect on output gap through the FOC of the consumers. Finally, it is worth noting
that, due to the backward-looking part of the model, I have obtained a forward-looking
Taylor rule; forward-looking not only because interest rate reacts to expected ination, but
also to expected output gap; so "backwardness" can be seen as a microfoundation for this
type of rules.
4.2 The Case of an Exogenous Fiscal Expenditure
Households should not change their behavior with respect to the previous section. Firms,
however, must now consider governments demand for goods and the central bank, must
now take into account the governments expenditure level before solving its problem. This
section describes these changes.
4.2.1 Firms
There are two major considerations in this setting. First of all, distorted sales taxes t
t
levied
by the government must be considered and second, now equilibrium needs j
)t
= c
)t
q
)t
;
where q
)t
is the symmetric denition for the government demand of individual good ,.
Using this, it can be shown that j
),t+i
= (
j
I
1
I+.
)

C
T
t+i
, where C
T
t
is total consumption of
composite good (private: C
t
and public: G
t
). Then, the forward-looking rms problem
can be rewritten as:
max
j
]o
I
1
t
1

i=0
.
i
^
i,t+i
[(
j
)c
)t
1
t+i
)
1
(1 t
t+i
) c
t+i
(
j
)c
)t
1
t+i
)

[C
T
t+i
The FOC for this problem is now given by:
j
)c
t
1
t
=

1
1
t

1
i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
)c
t+i
(
1
I+.
1I
)

1
t

1
i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
)(1 t
t+i
)(
1
I+.
1I
)
1
(14)
16
This is the same result as in the previous section, except that the optimal price is
now explicitly aected by the presence of the government consumption and the tax rate.
Considering a distorted tax rate makes the price charged by each forward-looking rm to
rise. This is a consequence of the type of tax assumed plus imperfect competition. If the
policymaker decides to rise taxes on sales, producers will, due to their monopolistic power,
transfer some portion of it to the consumers and thereby rise the price.
From the previous equation, government consumption has not a clear cut eect on
prices. However intuitively, as higher public consumption is assumed to be nanced only
trough taxes, scal expenditure should have a direct eect on prices. That is to say, the
scal authority must contract public expenditure if it does not want to put pressure on
prices. Ination rate is now given by:

t
= A
1
t
t
A
2
1
t

t+1
A
3

t1
A
4

c
t
(15)
where A: are dened in the appendix.
As well as in equation (12), ination is forward-looking, real marginal cost is a very
important determinant of the ination rate, but so are taxes in a positive way because of
rms monopolistic power, as explained earlier.
12
On the other hand, real marginal cost
can again be expressed as:

c
t
=
0
1
j o
0
1
( j
t
j
)
t
)
o0
G
0
1
( q
t
q
)
t
) (16)
where 0
1
is the private participation in total consumption, with 0
1
0
G
= 1. So, when
the governments behavior is taken into consideration, the real marginal cost deviation is
a weighted average of the output gap and the "public gap". If we think of j
t
as composed
by c
t
and q
t
, the later has a lower weight. If for example there is a positive productivity
shock and output increases, this pushes labor demand, which has a positive impact on real
wage and therefore on real marginal cost. However, higher private consumption has an
additional eect: higher consumption makes labor supply to contract, which means that
real wage must rise, as well as real marginal cost. This last eect is not present in public
consumption and that is why it has a lower weigh in the real marginal cost deviation.
12
Equation (15) is in line with the one found by Benigno and Woodford [2006] for the case of distortionary
sales taxes.
17
4.2.2 Government
When scal expenditure is considered to be an exogenous process, I will claim it is of the
form:
G
t
= G \t
So deviations around its steady state will be equal to zero in every moment of time
(i.e. q
t
= 0 \t) .
4.2.3 Central Bank
The central bank will again minimize its loss function subject to the demand and supply
side of the economy. Demand side is obtained from the linelization of the Euler equation.
Recalling that the output gap is dened as r
t
= j
t
j
)
t
where goods market equilibrium
imply j
t
= 0
1
c
t
0
G
q
t
and exogenous scal expenditure implies q
t
= 0; it will still be true
that the 1o curve for this economy will be simply given by the linelization of the Euler
equation. Dierent from the previous section, deviations of real marginal cost do take into
account the presence of the government and therefore the central banks problem is now
given by:
min

I+.
,a
I+.
,i
I+.
1
t
1

i=0
,
i
(
1
2

2
t+i

`
2
r
2
t+i
)
:t :
r
t
= 1
t
r
t+1

0
1
o
1
t

t+1

0
1
,i
o

i
t
n
t

t
= A
1
t
t
A
2
1
t

t+1
A
3

t1
A
4
0
1
j o
0
1
r
t
The FOC of this problem still needs the output gap to behave as before, except that
now it must be considered the private participation in total output 0
1
:
r
t
1
t
r
t+1
=
A
4
(0
1
j o)
`0
1
1
t

t+1
,A
3
1
t
r
t+2

_
1
1
,
A
2
_
r
t
The optimal policy rule for the interest rate is now:

i
t
=
1
,i
_
1
oA
4
(j o)
`0
2
1
_
1
t

t+1

o
i0
1
A
3
1
t
r
t+2

o
,i0
1
_
1
1
,
A
2
_
r
t

o
,i0
1
n
t
(17)
18
So, the deviations of the interest rate around its steady state will behave in the same
way as when no government was considered.
4.3 The Case of a Self-interested Incumbent
To see the behavior of economic variables when political issues are considered, I use the
former except for the governments nature. As mentioned before, I assume politicians
are self-interested and like to consume for their own purposes the same type of goods as
households do, but to do this, the incumbent must be re-elected. However, re-election only
happens if voters nd that the incumbent did well during its term in oce in terms of con-
sumption and hours worked. That is to say, economic performance signals the incumbents
competence and voters reward competence with reappointment. So, to understand how
the incumbent decides on scal decits under this environment, it is useful to introduce
rst the timing of the events and then present his maximization problem.
4.3.1 Timing
I shall focus the attention just on period t as it is not the aim of this paper to explain the
economys behavior due to the existence of a political cycle but only due to an optimally
driven scal decision, I therefore assume terms last only one period. The timing is the exact
one as the described in the previous section, except that as far as re-election is concerned,
the individuals will have to vote not only considering economic results but also inferring the
governments competence. That is to say, during period t three dierent shocks occur: the
productivity and scal shocks introduced earlier and also a government competence shock
j
)
t
(, = a, /), which is private information for the government and may cause eective
expenditure to be dierent from what expected. That is to say, while the government can
commit to a tax code, it is uncertain (as well as citizens are) about the tax revenues it
will generate; and consequently on its expenditure level. Competence is a time persistent
variant process of the form:
j
)
t
= j
)
t
j
)
t1
; , = a, /
where j
)
t
and j
)
t1
are i.i.d. random variables with zero mean, known variance, distribution
function 1 (j) and density function ) (j) .
At the end of period t citizens can observe the tax rate, the eective level of public
19
expenditure and consequently the eective ination rate which can be dierent from the
one induced by the central bank because of the possibly dierent expenditure level. They
can also partially deduce governments competence; that is to say, they can guess j
t1
using information from the announced public expenditure. To see this, note that at the
beginning of period t, 1 (7
t
) = 1; 1 (-
t
) = 0; 1 (j
t
) = 0, so it must be true that:
G
oaac&acco
t
= 1(t
t
1
t
) j
t1
from where j
t1
can be obtained. On the other hand, competence is not fully reveled
because at the end of period t voters are not able to distinguish between the portion of
public expenditure due to the productivity shock and the portion due to the competence
shock j
t
, and so, they must infer this component. This is the scenario under which elections
take place at the end of period t.
4.3.2 Incumbents Maximization Problem
Policymakers are drawn randomly from citizenry and, since politicians are citizens, their
preferences are derived from the specication of the preferences of voters.
13
To capture
this idea, I assume that when a candidate wins the elections, it will be able to consume
the remaining fraction of public good by devoting the maximum amount of labor, to
the public sector. In contrast to Shi and Svenssons work I will not assume that while
being in power, the policymaker is able to extract some "ego rents" (these ego rents could
capture not only altruistic perceived benets, but also monetary private benets obtained
each period). Furthermore, I suppose that if the incumbent is defeated in any re-election
or voluntarily leaves the power, he never becomes a citizen again, i.e. there is no possibility
of a "political career" (when politicians leave the oce to work again in the private sector);
in other words, I will assume that no re-election entails minus innity utility. In this way,
the incumbents utility function is,
\
t
=
1

i=0
,
i
[
((1 c) G
t+i
)
1o
1 o


1+j
1 j
[d
i
13
In this sense, this model ts into the citizen-candidate framework in political economy. However in this
case politicians are "exogenous", that is to say, citizens do not choose weather to run for public oce or
not, it is random.
20
where d
i
is an indicator function that equals d
i1
if the politician is in power in period t = i
and zero otherwise; with d
0
= 1. Now, because of the competence shock, the governments
budget constraint is:
G
t
= t
t
1
t
-
t
j
t
The second idea to capture is that to hold oce it is necessary for the incumbent to
be re-elected. As long as re-election is concerned, suppose party a is in power in period
t, assuming that citizens do not vote strategically but sincerely, voter i will re-elect the
incumbent if
1
t
[l
o
(t 1)[ 1
t
[l
b
(t 1)[ 0
i
_ 0
Dierence in expected utility is given by:
1
t
[l
o
(t 1)[ 1
t
[l
b
(t 1)[ = (cG)
1o
_
1
t
q
o
t+1
1
t
q
b
t+1
_
C
1o
_
1
t
c
o
t+1
1
t
c
b
t+1
_

1+j
_
1
t
:
o
t+1
1
t
:
b
t+1
_
It must be noticed that while citizens can learn about the incumbents competence,
there is no way they can infer the challengers one and so 1
t
j
b
t+1
= 0. Taking expectation
to the governments budget constraint and using the fact that 1
t
j
o
t+1
= 1
t
j
o
t
; the Euler
equation and the linearized labor market equilibrium condition, the expected share of
votes (1o\ ) can be expressed in terms of dierences of expected ination and tax rates
as follows:
1o\ = Ii
_
0
i
_ 1
t
[l
o
(t 1)[ 1
t
[l
b
(t 1)[
_
= (cG)
1o
_
1
0
1
_
1
t
t
o
t+1
1
t
t
b
t+1
_

1
o
_
1
t

o
t+1
1
t

b
t+1
_

1
0
1
G
1
t
j
o
t
_

C
1o
o
_
1
t

o
t+1
1
t

b
t+1
_

1+j
j
_
1
t

o
t+1
1
t

b
t+1
_
1,2
Therefore, the 1o\ depends on the expected dierence of tax rates between the two
candidates, on expected dierence of ination rates and on the expected incumbents com-
petence, all of which have a clear-cut eect. Higher taxes is the other side of higher public
expenditure and higher public expenditure raises utility because a fraction c of it is re-
turned to households; this same logic applies for expected competence as higher public
expenditure can also be due to the incumbentss competence. As long as expected ina-
tion is concerned, higher ination rate tomorrow means lower expected consumption which
21
lowers expected utility.
To obtain the re-election probability it is necessary to notice rst that the term
(cG)
1
0
T
G
will be always positive for positive values of scal expenditure. Therefore, if candidate ,
wins the oce with simple majority, the incumbent will be re-elected if the expected share
of votes exceeds 1,2; in this way, using steady state relations, the probability of re-election
I is:
I = Ii (1o\ _ 1,2)
= Ii
_
j
o
t
_ G
_
1
t
t
o
t+1
1
t
t
b
t+1
_
I

_
1
t

o
t+1
1
t

b
t+1
__
= 1 1
_
G
_
1
t
t
o
t+1
1
t
t
b
t+1
_
I

_
1
t

o
t+1
1
t

b
t+1
__
(18)
where I

=
(cG)
1
0
T
G
_
(cG)
1
o

C
1
o

.
1+
j
_
0. The rst thing to notice is that if
ination and taxes are expected to be the same between the incumbent and the challenger,
the incumbent will be reelected with probability one, this is because voters can learn
something about the incumbent but know nothing about the challenger. Also, we can see
that raising tax rates raises re-election probability but raising expected ination lowers this
probability for the reasons given above.
Now, to see the incumbents maximization problem, note that it will have no incentives
to manipulate expenditure to impress voters beyond period t 1. This is because the
probability of re-election at the end of t 1, which determines periods t 2 outcome, will
be inuenced by the incumbents expected competence at t 2. The fact that competence
is a MA(1) process, autocorrelation of order two or higher is zero. In other words, expected
competence in t2 is independent of actual competence, i.e., 1
t
_
j
t+2
,j
t
_
= 1
t
_
j
t+2
_
= 0.
So, the incumbent will be interested in maximizing its total expected utility only over
the next two periods by choosing the optimal tax rate, that is to say, the incumbents
22
maximization problem is given by:
max
tI
1
t
[(1 c) G
t
[
1o
1 o
,I1
t
[(1 c) G
t+1
[
1o
1 o
:t :
I = 1 1
_
G
_
1
t
t
o
t+1
1
t
t
b
t+1
_
I

_
1
t

o
t+1
1
t

b
t+1
__
1
t

t+1
=
A
1
1 A
2
A
3
1
t
t
t+1

A
2
1 A
2
A
3
1
t

t+2

A
4
1 A
2
A
3
1
t

c
t+1

A
1
A
3
1 A
2
A
3
t
t

A
3
A
4
1 A
2
A
3

c
t

A
2
3
1 A
2
A
3

t1

c
t
=
0
1
j o
0
1
( j
t
j
)
t
)
o0
G
0
1
( q
t
q
)
t
)
j
t
= 0
1
c
t
0
G
q
t
a:d G
t
= t
t
1
t
-
t
j
t
/o|d: \t
The FOC for the former problem leads to the following optimal consumption path:
1
t
G
o
t
= ,) ()
I

A
3
A
4
j0
G
(1 o) (1 A
2
A
3
) G
1
t
G
1o
t+1
(19)
where = G
_
1
t
t
o
t+1
1
t
t
b
t+1
_
I

_
1
t

o
t+1
1
t

b
t+1
_
. This equation shows that a self-
interested incumbent will also equalize marginal benet of public expenditure to marginal
cost. Marginal benet is independent from the fraction c of public good that is returned to
households (this is because of the functional form assumed for the preferences and therefore
c is not only aecting the marginal benet, but also the marginal cost; that is to say, the
incumbent does not care the percentage of public expenditure it can appropriate as long
it is positive (i.c.0 < c < 1) and does not change over time) and equals the consumption
level the incumbent can have today. Marginal cost is equal, on the other hand, to the
consumption level he is giving up tomorrow times the change in the re-election probability
he causes when he raises scal expenditure today and therefore puts pressure on ination.
4.3.3 Central Bank
I will linearize the equation for optimal scal expenditure and use it as the public component
of the output gap; the private component will be given again by the Euler equation. The
23
central banks problem is, therefore,
min

I+.
,a
I+.
1
t
1

i=0
,
i
(
1
2

2
t+i

`
2
r
2
t+i
)
:t :
r
t
= 1
t
r
t+1

0
1
o
1
t

t+1

0
1
,i
o

i
t

0
G
o
1
t
q
t+1
n
t

t
= A
1
t
t
A
2
1
t

t+1
A
3

t1
A
4
_
0
1
j o
0
1
r
t

o0
G
0
1
( q
t
q
)
t
)
_
The optimal policy rule for the interest rate is now:

i
t
=
o
0
1
,i
_
0
1
o

A
4
(0
1
j o)
`0
1
_
1
t

t+1

o
i0
1
A
3
1
t
r
t+2

o
,i0
1
_
1
1
,
A
2
_
r
t

0
G
o
0
1
,i (1 o)
q
t

o
0
1
,i
n
t
(20)
While it is still true that this is a forward-looking type of interest rate rule, comparing
the two interest rules obtained (equations (17) and (20)), the rst thing to notice is that now
the best response of the central bank should explicitly consider governments deviations
with respect to is steady state. If the incumbent rises scal expenditure such that it
overheats the economy, the central bank, in response to his loss function, must rise the
interest rate to cool down the economy. This is a signaling eect for the government of
how committed is the central bank with ination; when scal expenditure is given by an
exogenous process, the central bank can do nothing to change its level; however, if scal
expenditure is handled with discretion, it can somehow threaten him in order not to put
so much pressure on ination. Furthermore, the bigger the public sector relative to the
private one, the more responsive the monetary authority should be.
5 Economys Response to Shocks
I will allow scal expenditure to have a one percent external shock (explained for example
with a natural catastrophe or the implementation of a public policy that required more
resources than expected); and see how should the central bank react in both scenarios: when
scal expenditure is given and when it is endogenously determined. I will use the Rotenberg
and Woodford [1997] calibration for US data; a value of seventy percent for the fraction
of rms using the backward-looking rule (Gal and Gertler [1999] mention a value between
24
sixty and eighty percent of rms adjusting prices in a backward-looking way); a relative
low fraction of scal expenditure returned to households and a weigh of thirty percent for
the relative importance of output gap in the central banks loss function. In this way, the
set of parameters to be used are: , = 0.00; . = 0.8; o = 0.17; j = 0.2; O = 0.7; c = 0.1
and c = 0.1. Relevant equations for the impulse response functions are:
Linearized Euler equation;
Linearized labor supply;
Linearized labor demand,
Ination equation (HNKPC);
Linearized FOC for the government;
Linearized governments budget constraint and
Optimal interest rate rule.
The resulting policy and transition functions are as follows:

i
t
= 4.44
t1
0.0281-
t

t
= 0.0021
t1
0.080-
t
q
t
= -
t
t
t
= 0.8406
t1
0.0740-
t
c
t
= 0.8714
t1
0.088-
t
:
t
= .
t1
0.2016
t1
0.0281-
t
when scal expenditure is considered as an exogenous process, and:

i
t
= 0.066 q
t1
4.44
t1
0.872-
t

t
= 0.0060 q
t1
0.0021
t1
0.0878-
t
q
t
= 0.1862 q
t1
-
t
t
t
= 0.1774 q
t1
0.8406
t1
0.02-
t
c
t
= 0.0022 q
t1
0.8714
t1
0.012-
t
:
t
= .
t1
0.0017 q
t1
0.2016
t1
0.0004-
t
25
when scal expenditure is considered as an endogenous process.
Figure 1 presents the impulse response functions for a one percent scal shock; the
doted line represents the case where scal expenditure is an exogenous process while the
solid line represents the case where scal expenditure is manipulated by a self-interested
incumbent. The main dierence between the two lines, and my main focus, is how reactive
the interest rate is in each scenario. While in the case of an exogenous scal process the
interest rate must rise by 0.080 to a scal shock, in the case of an endogenous scal policy
it must rise by 0.872. That is to say, the central bank must react in a signicantly higher
way to a scal shock to give the government a suitable signal of how committed it is to
its ination target. This is purely signaling as, due to the economys structure, inations
reaction is not signicantly dierent in both scenarios. We can also see that a one percent
shock to scal expenditure makes tax rate to rise a little less than proportional, this is
because total output (the tax base) will be lower after the shock. This is because even
though the increase of scal expenditure relative higher than the decrease in consumption,
the parameter set used implies a very low scal participation in total output, 0
G
. Thereby,
the increase of total output ends up being lower than 1/ and so is the increase in the tax
rate. It is also true that, starting from the steady state, higher scal expenditure puts
inationary pressures and therefore the central bank must contract the economy. This
higher interest rate level has a negative impact on consumption and this has a positive
impact on labor; this is why consumption and labor react in a very similar way (though
26
opposite in sign).
Interest Rate
-0,05
0
0,05
0,1
0,15
0,2
0,25
0,3
0,35
0,4
1 2 3 4 5 6 7 8 9 10
End Exo
Inflation
-0,01
-0,005
0
0,005
0,01
0,015
0,02
0,025
0,03
0,035
0,04
1 2 3 4 5 6 7 8 9 10
End Exo
Fiscal Expenditure
-0,4
-0,2
0
0,2
0,4
0,6
0,8
1
1,2
1 2 3 4 5 6 7 8 9 10
End Exo
Tax Rate
-0,4
-0,2
0
0,2
0,4
0,6
0,8
1
1,2
1 2 3 4 5 6 7 8 9 10
End Exo
Consumption
-0,04
-0,035
-0,03
-0,025
-0,02
-0,015
-0,01
-0,005
0
0,005
1 2 3 4 5 6 7 8 9 10
End Exo
Labor
-0,005
0
0,005
0,01
0,015
0,02
0,025
0,03
1 2 3 4 5 6 7 8 9 10
End Exo
1ij&vc 1: 111
0
c tc o 1% 1icco| SIccI
27
6 Extension: The Case of a Benevolent Government
In the previous sections I have obtained the optimal interest rate rule that came up when
scal and monetary authorities are not coordinated and have opposite interests. That is to
say, I have answered the question of how monetary policy be conducted if the central bank
is concerned with individuals welfare but the government is only concerned with his own
welfare (in terms of consumption and re-election). Monetary authority should behave in a
dierent, and in particular in a more aggressive way, when the government has incentives
to manipulate scal expenditure in order to maximize his own consumption and re-election
probability, compared to the case where scal expenditure is an exogenous process. That
is to say, the fact that scal and monetary authorities incentives are not aligned makes
the central bank be willing to signal its commitment to ination and rise the interest rate
whenever the government rises scal expenditure beyond its steady state level.
This section on the other hand, poses the question of how monetary policy should be
conducted is scal and monetary authorities incentives are aligned. That is to say, if not
only the central bank but also the government is concerned with individuals welfare. This
assumption gives us a very interesting scenario where the institutionality underlying has
guaranteed not only the use of the interest rate but also os scal expenditure in favor
of individuals welfare; as can be expected to be in countries that actually use ination
targeting.
6.1 Government
To obtain the optimal interest rate rule, three things must be noticed. First, households
should not change their behavior with respect to the previous sections. Second, rms
must still consider governments demand for goods; and nally, there is no reason why a
benevolent incumbent should not be reappointed in oce. A benevolent incumbent should
always be reappointed because it is known by voters that he will have no incentives (or no
means) to appropriate from a portion of public expenditure; so the challenger should not be
any dierent from the incumbent.
14
In this way, a benevolent planner will be interested in
setting scal expenditure as to maximize the representative households utility, aware that
the consumer will set its allocation eciently where the Euler equation holds and marginal
14
Another way to deal with this issue is to assume that the incumbent wins the elections with an exogenous
probability . Considering 8t is just a special case that has no impact in the optimal interest rate rule
obtained.
28
utility of private consumption and leisure are equal. Moreover, the problem will also be
restricted by the prot maximization of rms through the HNKPC (considered one period
ahead) and market clearing: a feasibility condition that private and public consumption
should not exceed output, and labor demand equalizing labor supply. So, the benevolent
planners problem will be:
max
GI
1
t
1

i=0
,
i
[
(cG
t+i
)
1o
1 o

C
1o
t+i
1 o

_
1
0

1+j
)t+i
d,
1 j
[
:.t. :
C
o
t
= ,(1 i
t
)1
t
1
t
1
t+1
C
o
t+1
;

j
t
C
o
t
=
n
t
1
t
; (1a/or onjj|j)
1
t

t+1
=
A
1
1 A
2
A
3
1
t
t
t+1

A
2
1 A
2
A
3
1
t

t+2

A
4
1 A
2
A
3
1
t

c
t+1

A
1
A
3
1 A
2
A
3
t
t

A
3
A
4
1 A
2
A
3

c
t

A
2
3
1 A
2
A
3

t1

c
t
=
0
1
j o
0
1
( j
t
j
)
t
)
o0
G
0
1
( q
t
q
)
t
)
1
t
_ C
t
G
t

t
=
1
t
&I
1I
; (1a/or 1c:a:d)
a:d G
t
= t
t
1
t
-
t
/o|d: \t
Optimal expenditure must then satisfy:
c
1o
G
o
t
,
j
o1
A
3
A
4
1 A
2
A
3
(1 i
t
) C
1o
t
1
t
C
o
t+1
(1
t+1
)
2
_
1
o
1 j

j1
t
(C
t
G
t
)
_
=

j1
t
1 j
C
o
t
_
1 ,
j
o1
A
3
A
4
1 A
2
A
3
(1 i
t
) 1
t
C
o
t+1
(1
t+1
)
2
_
(21)
So, a benevolent government equals marginal benet of public expenditure to its mar-
ginal cost. The former is given by the direct eect of scal expenditure on utility, the term
c
1o
G
o
t
and the indirect eect of scal expenditure on utility through expected ination.
Higher expenditure today means, ceteris paribus, higher expected ination for tomorrow,
29
which lowers real interest rate; the Euler equation says households will make intertemporal
substitution raising present consumption and therefore utility. The second part of this
indirect eect says that higher consumption today makes labor supply to contract, making
households to work fewer hours which raises utility even further. Marginal cost of public
consumption has, likewise, a direct and indirect eect. Higher public consumption pushes
aggregate demand so that production must raise and so must labor demand. higher labor
demand means more hours devoted to work and therefore lower utility. The indirect eect
is again a consequence of the ination channel. As mentioned before, public expenditure
has a positive eect on current consumption through expected ination. This in turn has
a positive eect on aggregate demand that expands further with the consistent decrease in
utility.
6.2 Central Bank
The central bank will again minimize its loss function subject to the demand and supply
side of the economy. As in the previous section, let r
t
= j
t
j
)
t
be the output gap with
respect to the exible price case; recalling that j
t
= 0
1
c
t
0
G
q
t
, linealization of the FOC for
the incumbent (which already incorporates the linearization of the Euler equation) results
in the demand side, whereas the supply side is given by the HNKPC. The central banks
problem is now as follows:
min

I+.
,a
I+.
1
t
1

i=0
,
i
(
1
2

2
t+i

`
2
r
2
t+i
)
:t :
r
t
= 1
t
r
t+1
0
G
1
1
1
t

t+1
(0
G
1
2
0
1
) c
t
0
G
1
3

i
t
0
G
1
4
:
t
(0
G
1
5
0
1
) 1
t
c
t+1
0
G
1
t
q
t+1
n
t

t
= A
1
t
t
A
2
1
t

t+1
A
3

t1
A
4
_
0
1
j o
0
1
r
t

o0
G
0
1
( q
t
q
)
t
)
_
where coecients 1
0
: are dened in the appendix. The FOC of this problem still needs
the output gap to behave as before:
r
t
1
t
r
t+1
=
A
4
(0
1
j o)
`0
1
1
t

t+1
,A
3
1
t
r
t+2

_
1
1
,
A
2
_
r
t
30
The optimal policy rule for the interest rate is now:

i
t
= c
1
1
t

t+1
c
2
r
t+2
c
3
r
t
c
4
1
t
c
t+1
c
5
q
t
c
6
1
t
q
t+1
n
t
(22)
where the c
0
: and n
t
are dened in the appendix. In this way, I obtain an interest rate
rule that once again is dierent from the one found in Clarida et al (i
t
= i (1
t

t+1
; q
t
))
but not dierent from more general specications of forward looking Taylor rules.
15
I
would like to highlight four things about this last equation. First, equation (22) says
that the monetary authority sets the interest rate using the information available in t to
forecast ination and public and private consumption for next period; so, this interest
rate rule that explicitly incorporates the optimal decision problem of a benevolent planner
also gives microfoundations to forward looking Taylor rules. However, in contrast to the
optimal interest rate rule found for the case of a self-interested incumbent, the forward-
looking part is independent of "backwardness"; that is to say, even in the special case
where all rms adjust prices in a forward-looking way (i.e. c
2
= c
3
= 0) I would still
obtain a microfounded forward-looking Taylor rule. Another important result is that (22)
tells us that the presence of a government (even a benevolent one) must alter the central
banks behavior. The central bank must explicitly consider scal policy not only because
this model assumes that a fraction of public expenditure is returned to households, but
also (and more relevant) because public expenditure aects expected ination a that has
a direct eect on households welfare through private consumption.
16
In third place, and
closely related to the previous point, optimal interest rate rules for the case of a benevolent
planner diers from the one for the case of a self-interested incumbent in the fact that for the
former, the central bank is also concerned about expected deviations of scal expenditure
the next period. The intuition behind this result is that when a self-interested incumbent
is in charge of scal policy, he faces a trade-o between actual expenditure and re-election
probability. If the self-interested incumbent rises scal expenditure beyond its steady
state level, it is expected to be lower tomorrow so that his re-election probability does
not drop deeply. So, deviations of scal expenditure today have information about scal
expenditure tomorrow and in this way, q
t
turns to be the relevant variable for the central
banks decisions. This trade-o however, is no longer present when scal expenditure is
15
Of the form iI = i +c
r
(
c
I+1
) +c
i
r
c
I+1
.
16
This result does not change if the game between the government and the central bank would be
simultaneous.
31
in charge of a benevolent planner; so the central bank must also consider expected scal
expenditure tomorrow before setting the interest rate. Finally, it is possible to show that
for certain parameters values (in particular for c and o suciently low), contrary to what
the optimal interest rate rule tells us when the government is purely self-interested, interest
rate is less reactive the bigger is the public sector relative to the private sector. This is
because incentives are now aligned and both authorities are looking forward individuals
welfare; so if the public sector is relatively large, the central bank can somehow rest on the
government and need not to have a so aggressive policy.
7 Conclusion
Governments do not always take their scal decisions thinking about individuals welfare
but thinking only in their owns. This has a great impact on the decisions an independent
and welfare-concerned central bank makes. In this paper I have used a general equilibrium
model with nominal rigidities (staggered prices) and ination inertia that comes from the
assumption that a fraction of rms behave in a backward-looking way. This model has
enabled me to study how does optimal interest rate rules should change when there is
no government and when government expenditure is considered as an exogenous process
or is in charge of a self-interested incumbent that reveals its competence only partially.
The main contribution of this paper is the interaction between the central bank and a
self-interested incumbent whose trade-o is given by the fact that he would like to rise
todays expenditure level in order to appropriate from a fraction of it but, starting from
the steady state, scal expenditure puts inationary pressures in the economy. Due to
ination inertia present, higher ination today implies higher ination tomorrow, and this
aects in a negative way to the incumbents re-election probability, which clearly curbs
scal decision.
At the beginning of the paper, in the introduction, I put forward regression results for
Australia, Chile and Peru that showed that target interest rates react dierently in each
country. The Federal Reserve Bank of Australia has a very little response (and even not
statistically signicant) to a 1/ change in scal expenditure; while this is considerably
larger in Chile and Peru. In tune with this observation, the main result of the paper is
that if scal expenditure is given by an exogenous process, then the central bank can do
nothing to change it and therefore, the optimal interest rate rule says that deviations of the
nominal interest rate should not consider scal expenditure at all; as if no government was
32
present. When scal expenditure is, on the other hand, manipulated by a self-interested
incumbent, then the central bank should signal how much it is willing to defend ination
and rise the interest rate above its steady state level. This over-reaction is bigger the bigger
the public sector is relative to the private sector.
Starting form the steady state, if I disturb the economy with a 1/ scal shock, impulse
response functions tell us that the interest rate response is ten times larger with a self-
interested incumbent than with an exogenous process. This over-reaction is, as implied by
the model, purely a signaling eect as the change in ination does not dier signicantly
in both scenarios (this is clearly due to the economys structure).
Another result is that, considering a fraction of rms that set prices in a backward-
looking way results in a forward-looking Taylor rule. It is a forward-looking Taylor rule
not only because interest rate reacts to expected ination, as happens to be in standard
models, but also because interest rate reacts to expected output gap. In this way, this
model gives a microfoundation to this type of rules.
Finally, if instead of a self-interested incumbent I assume the governments and central
banks incentives are aligned in such way that they both care about individuals welfare, I
nd that the optimal interest rate rule must consider not only deviations of scal expendi-
ture two periods ahead (which is a consequence of the backward-looking assumption of the
model), but must also consider deviations of scal expenditure for the next period. The
intuition behind this result is that when the government behaves as a benevolent planner
there no longer exists the trade-o between actual expenditure and re-election probability.
In this way, actual deviations of scal expenditure tells nothing to the central bank about
tomorrows level of public consumption (relative to its steady state level) and therefore the
central bank must use the information available in t to forecast scal expenditure in t 1.
Furthermore incentives alignment enables the monetary authority to be less reactive to de-
viations of scal expenditure; that is to say, the central bank should response to deviations
of public consumption in a more friendly way if it knows the government is manipulating
his consumption not to maximize his own utility but to maximize individuals one.
33
A Appendix A: Regressions
For the regressions mentioned in the introduction I used target interest rates declared by
central banks, seasonally adjusted public consumption and the percentage change in CPI
index for Australia, Chile and Peru. Data was collected from the websites of the central
banks and national statistical oces of each country. Regressions were run in logs for
the target interest rates and scal expenditure so that the estimated coecients are the
elasticity of interest rate with respect to scal expenditure; ination was considered in
percentages. As an independent variable, scal expenditure was introduced with one lag
because information on GDP is available with some delay (in fact this is the reason why I
did not include the last quarter of 2008 in the data). The estimation method was simply
OLS. Output windows are the following:
Table 1 - Regressions
Dependent Variable: log(Target Interest Rate)
Country Australia Chile Peru
Method OLS OLS OLS
Observations 62 21 16
log(Fiscal Expenditure) 0.02171 2.02405* 0.95506*
(0.8796) (0.0000) (0.0035)
Ination 0.08658** 0.108*** -0.01873
(0.0176) (0.01018) (0.7967)
* Signicant at the 1% level
** Signicant at the 5% level
*** Signicant at the 10% level
p-values shown in parenthesis
34
B Appendix B: Solving the Model
B.1 Households
Consumers problem is solved in two stages: rst minimize the cost of buying a certain
level of composite good C
t
and then maximize their utility function subject to their budget
constraint. Minimization implies the solution of the following problem:
min
c
I
_
1
0
j
)t
c
)t
d,
:.t : C
t
_ [
_
1
0
c
1

)t
d,[

1
Let c
t
be the lagrange multiplier associated to the constraint, the FOC with respect to c
)t
is:
j
)t
= c
t
[
_
1
0
c
1

)t
d,[

1
1
c

)t
But [
_
1
0
c
1

)t
d,[
1
1
= C
1

t
, so the former condition can be rewritten as:
j
)t
= c
t
C
1

t
c

)t
c
)t
= C
t
_
j
)t
c
t
_

Using the denition of the composite good:

C
t
=
_
1
0
c
1

)t
d,[

1
C
t
= [
_
1
0
C
1

t
_
j
)t
c
t
_
1
d,[

1
=
c

t
= [
_
1
0
j
1
)t
d,[

1
c
t
= [
_
1
0
j
1
)t
d,[
1
1
= 1
t
35
Substituting the denition of the lagrange multiplier in the FOC obtained earlier, I obtain
the demand for individual good , :
c
)t
= C
t
_
j
)t
1
t
_

The second step will give us the Euler equation and the labor supply:
max
CI,.I,1I
1
t
1

i=0
,
i
[
(cG
t+i
)
1o
1 o

C
1o
t+i
1 o

_
1
0

1+j
)t+i
d,
1 j
0
c

t+i
[
:.t : C
t

1
t
1
t
=
n
t
_
1
0

)t
d,
1
t
(1 i
t1
)
1
t1
1
t
H
t
Let i
t
be the corresponding lagrange multiplier; then FOC with respect to C
t
; C
t+1
;
)t
and 1
t
are, respectively:
C
o
t
= i
t
,1
t
C
o
t+1
= i
t+1

j
)t
= i
t
n
t
1
t
i
t
1
t
= (1 i
t
)
i
t+1
1
t+1
Using the fourth FOC and combining the rst three, I obtain the Euler equation (equation
(8)) and labor supply (equation (0)):
C
o
t
,1
t
C
o
t+1
= (1 i
t
)
1
t
1
t+1
=
C
o
t
= , (1 i
t
) 1
t
1
t
1
t+1
C
o
t+1
a:d

j
)t
= C
o
t
n
t
1
t
B.2 Firms
Let me rst obtain equation (1) and then show that (12) is just a special case when
no government is considered. Forward-looking rms, as well as consumers, also have a
two-step solution to set their optimal price; they rst minimize costs from where the real
marginal cost is obtained and then choose the price j
)t
that maximizes the present value
36
of expected utilities. The rst part of the problem implies solving:
min
.
I
n
t
1
t

)t
:.t : j
)t
= 7
t

)t
Let c
t
be the lagrange multiplier, then, the FOC is:
c
t
=
&I
1I
7
t
So, c
t
is the real marginal cost. On the other hand, each rm must face the demand for its
dierentiated product, then total demand of product ,
_
c
T
)t
_
is given by individual demand
from households and government:
c
T
)t
= c
)t
q
)t
= C
t
_
j
)t
1
t
_

G
t
_
j
)t
1
t
_

=
_
j
)t
1
t
_

(C
t
G
t
)
=
_
j
)t
1
t
_

C
T
t
Imposing market clear condition for goods, it must be true that:
j
)t
= c
T
)t
=
_
j
)t
1
t
_

C
T
t
Then the pricing decision for the forward-looking rm can be expressed as:
max
j
]o
I
1
t
1

i=0
.
i
^
i,t+i
[(
j
)c
)t
1
t+i
)
1
(1 t
t+i
) c
t+i
_
j
)c
)t
1
t+i
_

[C
T
t+i
37
The FOC with respect to the optimal price is:
1
t
1

i=0
.
i
^
i,t+i
[(1 ) (
j
)c
)t
1
t+i
)

(1 t
t+i
)
1
1
t+i
c
t+i
_
j
)c
)t
1
t+i
_
1
1
1
t+i
[C
T
t+i
= 0
As all rms face the same problem, they will all set the same optimal price j
)c
t
so that:
1
t
1

i=0
.
i
^
i,t+i
[(1 ) (
j
)c
t
1
t+i
)(1 t
t+i
) c
t+i
[C
T
t+i
1

t+i
= 0
Recall that the stochastic discount factor is ^
i,t+i
= ,
i
(C
t+i
,C
t
)
o
, so j
)c
t
must satisfy:
1
t
1

i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
) [(1 )
j
)c
t
1
t
1
t
1
t+i
(1 t
t+i
) c
t+i
[1

t+i
= 0
Then solving for
j
]o
I
1I
:
j
)c
t
1
t
=

1
1
t

1
i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
)c
t+i
(
1
I+.
1I
)

1
t

1
i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
)(1 t
t+i
)(
1
I+.
1I
)
1
The optimal price set by each forward and backward-looking rm must be linearized
around its steady state in order to obtain the HNKPC, where ination is dened as
t
=
ln
_
1I
1
I1
_
. To obtain equation (1) lets rst dene Q
t
as the relative price a rm sets
when it has to adjust prices, so Q
t
=
j

I
1I
; note that in steady state, when all rms can
adjust prices it must be true that, Q
SS
= 1; and also note that
t
= ln
_
QI
Q
SS
_
. Secondly,
we know that the general price level 1
t
is a weighted average between the price set by
adjusting rms and the general price level the period before; I also have an equation for
the optimal price set by adjusting rms (forward and backward-looking) and nally, the
FOC for forward-looking rms. So the relevant equations are:
Q
t
=
j

t
1
t
; Q
)c
t
=
j
)c
t
1
t
; Q
bo
t
=
j
bo
t
1
t
(B.1)
1
1
t
= (1 .)(j

t
)
1
.1
1
t1
(B.2)
38
j

t
= (1 O) j
)c
t
Oj
bo
t
(B.3)
j
bo
t
= j

t1
(B.4)
j
)c
t
1
t
=

1
1
t

1
i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
)c
t+i
(
1
I+.
1I
)

1
t

1
i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
)(1 t
t+i
)(
1
I+.
1I
)
1
(B.5)
Expressing (1.2) in percentage deviations around the steady state, we can see that:
1 = (1 .)(
j

t
1
t
)
1
.
_
1
t1
1
t
_
1
=
0 = (1 .)
t
.
t

t
=
.
1 .

t
From (1.4) , I can express the price set by backward-looking rms as:
j
bo
t
1
t
=
j

t1
1
t1
1
t1
1
t
=
Q
bo
t
= Q
t1
1
t1
1
t
=

bo
t
=
t1

t
I can use this in (1.8), previously expressed in percentage deviations around the steady
state:
Q
t
= (1 O) Q
)c
t
OQ
bo
t
=

t
= (1 O)
)c
t
O
bo
t
=

t
= (1 O)
)c
t
O
t1
O
t
Leaving this aside for a moment, note that if for simplicity I dene j =

1
, (1.) can
39
be expressed as:
Q
t
_
1
t
1

i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
)(1 t
t+i
)(
1
t+i
1
t
)
1
_
= j1
t
1

i=0
.
i
,
i
C
o
t+i
(C
t+i
G
t+i
)c
t+i
(
1
t+i
1
t
)

So that the LHS (which I will denote by O) can be approximated by:

O - O(oo)
0O
0Q
t+i

SS
_
Q
)c
t+i
1
_

0O
0C
t+i

SS
(C
t+i
C)
0O
0G
t+i

SS
(G
t+i
G)

0O
0t
t+i

SS
(t
t+i
t)
0O
0
1
I+.
1I

SS
_
1
t+i
1
t
1
_
(a) O(oo) =
C

(C+G)(1t)
1.o
(b)
0
0Q
I+.

SS
(Q
t+i
1) =
C

(C+G)(1t)
1.o

)c
t
(c)
0
0C
I+.

SS
(C
t+i
C) = (1 t)

i
.
i
,
i
_
(1 o) C
1o
oC
o
G

1
t
c
t+i
(d)
0
0G
I+.

SS
(G
t+i
G) = (1 t)

i
.
i
,
i
C
o
G1
t
q
t+i
(e)
0
0t
I+.

SS
(t
t+i
t) = tC
o
(C G)

i
.
i
,
i
1
t
t
t+i
(f )
0
0
T
I+.
T
I

SS
_
1
I+.
1I
1
_
= (1 t) C
o
(C G)

i
.
i
,
i
( 1) (1
t
j
t+i
j
t
)
On the other hand, denote the RHS by 1, so that it can be approximated by:
1 - 1(oo)
01
0C
t+i

SS
(C
t+i
C)
01
0G
t+i

SS
(G
t+i
G)

01
0c
t+i

SS
_
c
t+i
c
_

01
0
1
I+.
1I

SS
_
1
t+i
1
t
1
_
(a) 1(oo) =
C

(C+G)j
1.o
40
(b)
0
0C
I+.

SS
(C
t+i
C) = jc

i
.
i
,
i
_
(1 o) C
1o
oC
o
G

1
t
c
t+i
(c)
0
0G
I+.

SS
(G
t+i
G) = jc

i
.
i
,
i
C
o
G1
t
q
t+i
(d)
0
0
I+.

SS
_
c
t+i
c
_
= jcC
o
(C G)

i
.
i
,
i
1
t

c
t+i
(e)
0
0
T
I+.
T
I

SS
_
1
I+.
1I
1
_
= jcC
o
(C G)

i
.
i
,
i
(1
t
j
t+i
j
t
)
Equating both sides and canceling terms:
j
)c
t

)c
t
= (1 .,)
_
t
1 t

i
.
i
,
i
1
t
t
t+i

i
.
i
,
i
_
1
t

c
t+i
1
t
j
t+i
_
_
I can then bring forward this expression, take the expected value in t and then replace
it again in the previous equation so that j
)c
t
and
)c
t
will be expressed only in terms of
j
)c
t+1
and
)c
t+1
:

)c
t
= (1 .,)
_
t
1 t
t
t


c
t
_
.,1
t

)c
t+1
.,1
t

t+1
It is also possible to express 1
t

)c
t+1
in terms of 1
t

t+1
;
t
and 1
t

t+1
. Finally, recall
that

t
=
.
1 .

t
=
1
t

t+1
=
.
1 .
1
t

t+1
Substituting these two equations in the resulting one from the previous steps, I can
obtain an expression for the ination rate, which is equation (1) :

t
= A
1
t
t
A
2
1
t

t+1
A
3

t1
A
4

c
t
41
where
A
0
=
_
.
1 .

.,O
1 O
O
_
1
A
1
= A
0
(1 O) (1 .,)
t
1 t
A
2
= A
0
.,
(1 O)
_
O
.
(1 .)
_
A
3
= A
0
.O
1 .
A
4
= A
0
(1 O) (1 .,)
Note that for the special case where no government is considered, t = 0 and in that
way I obtain equation (12) .
B.3 Central Bank
In order to obtain the central banks best response function (18) , I must solve the following
problem:
min

I+.
,a
I+.
,i
I+.
1
t
1

i=0
,
i
(
1
2

2
t+i

`
2
r
2
t+i
)
:t :
r
t
= 1
t
r
t+1

1
o
1
t

t+1

,i
o

i
t
n
t

t
= A
2
1
t

t+1
A
3

t1
A
4
(j o) r
t
Let w
t
and 1
t
be the lagrange multipliers associated to the 1o and H11C curves
respectively; then the FOC whith respect to i
t+i
says that:
w
t+i
_
,
o
_
= 0
42
which implies that w
t
= 0\t; that os to say, the 1o curve is not an active restriction. In
this way, I can rewrite the central banks problem as:
min

I+.
,a
I+.
1
t
1

i=0
,
i
(
1
2

2
t+i

`
2
r
2
t+i
)
:t :

t
= A
2
1
t

t+1
A
3

t1
A
4
(j o) r
t
Let again 1
t
be the lagrange multiplier associated to the active restriction, the FOCs
with respect to
t+i
and r
t+i
respectively are:

t+i
1
t+i

A
2
,
1
t+i1
,A
3
1
t+i+1
= 0
`r
t+i
1
t+i
A
4
(j o) = 0
Then, using the value of the lagrange multiplier from the second equation and replacing it
in the rst one, I obtain:
1
t+i
=
`
A
4
(j o)
r
t+i
1
t+i1
=
`
A
4
(j o)
r
t+i1
1
t+i+1
=
`
A
4
(j o)
r
t+i+1
Therefore:

t+i
=
A
2
,
`
A
4
(j o)
r
t+i1

`
A
4
(j o)
r
t+i
,A
3
`
A
4
(j o)
r
t+i+1
=
1
t

t+1
=
`
A
4
(j o)
_
A
2
,
r
t
1
t
r
t+1
,A
3
1
t
r
t+2
_
=
r
t
1
t
r
t+1
= A
4
(j o) 1
t

t+1
,A
3
1
t
r
t+2

_
1
A
2
,
_
r
t
43
Now, replace this in the IS curve:
r
t
1
t
r
t+1
=
1
o
_
1
t

t+1
i,

i
t
_
n
t
(1o cnrc)
A
4
(j o) 1
t

t+1
,A
3
1
t
r
t+2

_
1
A
2
,
_
r
t
=
1
o
_
1
t

t+1
i,

i
t
_
n
t
The optimal interest rule is:

i
t
=
1
,i
_
1
oA
4
(j o)
`
_
1
t

t+1

o
i
A
3
1
t
r
t+2

o
,i
_
1
1
,
A
2
_
r
t

o
,i
n
t
If the government with an exogenous expenditure level is considered, the 1o curve is
still not binding, so the central banks problem is as follows:
min

I+.
,a
I+.
1
t
1

i=0
,
i
(
1
2

2
t+i

`
2
r
2
t+i
)
:t :

t
= A
1
t
t
A
2
1
t

t+1
A
3

t1
A
4
0
1
j o
0
1
r
t
This is because as G
t
= G\t, then q
t
= 0\t =r
t
= j
t
j
)
t
= 0
1
c
t
j
)
t
. The FOC are now:
1
t+i
=
`0
1
A
4
(0
1
j o)
r
t+i
1
t+i1
=
`0
1
A
4
(0
1
j o)
r
t+i1
1
t+i+1
=
`0
1
A
4
(0
1
j o)
r
t+i+1
Which implies:

t+i
=
`0
1
A
4
(0
1
j o)
_
A
2
,
r
t
1
t
r
t+1
,A
3
1
t
r
t+2
_
1
t

t+1
=
`0
1
A
4
(0
1
j o)
_
A
2
,
r
t
1
t
r
t+1
,A
3
1
t
r
t+2
_
r
t
1
t
r
t+1
=
A
4
(0
1
j o)
`0
1
1
t

t+1
,A
3
1
t
r
t+2

_
1
A
2
,
_
r
t
44
Once again, I replace this condition in the 1o curve:
r
t
1
t
r
t+1
=
0
1
o
_
1
t

t+1
i,

i
t
_
n
t
(1o cnrc) =

i
t
=
1
,i
_
1
oA
4
(j o)
`0
2
1
_
1
t

t+1

o
i0
1
A
3
1
t
r
t+2

o
,i0
1
_
1
1
,
A
2
_
r
t

o
,i0
1
n
t
For the case of a self-interested government the only dierence in the central banks
problem is given by the 1o curve as G
t
obeys equation (20):
r
t
1
t
r
t+1
=
0
1
o
_
1
t

t+1
i,

i
t
_

0
1
o
1
t
q
t+1
n
t
(1o cnrc)
Therefore:

i
t
=
o
0
1
,i
_
0
1
o

A
4
(0
1
j o)
`0
1
_
1
t

t+1

o
i0
1
A
3
1
t
r
t+2

o
,i0
1
_
1
1
,
A
2
_
r
t

0
G
o
0
1
,i (1 o)
q
t

o
0
1
,i
n
t
B.4 Extension: The Case of a Benevolent Government
To obtain the interest rate rule in the case of a benevolent planner, it is necessary rst to
solve the governments problem as follows:
max
GI
1
t
1

i=0
,
i
[
(cG
t+i
)
1o
1 o

C
1o
t+i
1 o

_
1
0

1+j
)t+i
d,
1 j
[
:.t. :
C
o
t
= ,(1 i
t
)1
t
1
t
1
t+1
C
o
t+1
;

t
=
_
(C
t
G
t
) C
o
t
1

1
t

t+1
=
A
1
1 A
2
A
3
1
t
t
t+1

A
2
1 A
2
A
3
1
t

t+2

A
4
1 A
2
A
3
1
t

c
t+1

A
1
A
3
1 A
2
A
3
t
t

A
3
A
4
1 A
2
A
3

c
t

A
2
3
1 A
2
A
3

t1

c
t
=
0
1
j o
0
1
(0
1
c
t
0
G
q
t
j
)
t
)
o0
G
0
1
( q
t
q
)
t
)
a:d G
t
= t
t
1
t
-
t
/o|d: \t
45
Where the rst restriction is the Euler equation and assures that individuals are maximizing
consumption; the second restriction implies that individuals are maximizing, labor market
is in equilibrium and also is goods market; and nally the fourth restriction assures again
goods market equilibrium. The FOC for this problem is:
c
1o
G
o
t
C
o
t
0C
t
0G
t

j
t
0
t
0G
t
= 0
Solving this condition considering the restrictions, I obtain equation (21) :
c
1o
G
o
t
,
j
o1
A
3
A
4
1 A
2
A
3
(1 i
t
) C
1o
t
1
t
C
o
t+1
(1
t+1
)
2
_
1
o
1 j

j1
t
(C
t
G
t
)
_
=

j1
t
1 j
C
o
t
_
1 ,
j
o1
A
3
A
4
1 A
2
A
3
(1 i
t
) 1
t
C
o
t+1
(1
t+1
)
2
_
This condition must be linearized. It is useful to redene some parameters, let:

1
= ,
j
o1
A
3
A
4
1 A
2
A
3

2
=
1
C
12o

3
=

j1
1 j

4
=
2
(1 i)
Then using steady state relations and ignoring second order terms, linealization implies:
2c
1o
G
o
1
t

t+1
oc
1o
G
o
q
t

3

4
oC (j 1) :
t

3

4
oCc
t

4
oG(j 1) :
t

3

4
oG q
t

4
i
1 i

i
t

4
(1 o) c
t

4
o (1 o) (C G) c
t

3

4
o (C G)
i
1 i

i
t

4
o1
t
c
t+1

4
o
2
(C G) 1
t
c
t+1
=
3
C
o
(j 1) :
t

3
C
o
oc
t
2
3
C
o
1
t

t+1

3
C
2o
(1 i) (j 1) :
t

3
C
2o
(1 i) oc
t

1

3
C
2o
i

i
t

3
C
2o
(1 i) o1
t
c
t+1
46
Solving for q
t
:
q
t
= 1
1
1
t

t+1
1
2
c
t
1
3

i
t
1
4
:
t
1
5
1
t
c
t+1
where:
1
0
=
_
o
_

4
Gc
1o
G
o
_
1
1
1
= 21
0
_

3
C
o
c
1o
G
o
_
1
2
= 1
0
_

4
(
3
o (1 o) (C G) (1 o)
3
oC)

3
_
C
o
o
1
C
2o
(1 i) o
_
_
1
3
= 1
0
i
_

3
C
2o

4
1
1 i

3

4
o (C G)
1
1 i
_
1
4
= 1
0

3
(1 j)
_

4
o (C G) C
o

1
C
2o
(1 i)

1
5
= 1
0
o
_

4

3

4
o (C G)
1

3
C
2o
(1 i)

To obtain the demand side of this economy, note that equation (21) already incorporates
the Euler equation for consumers. Therefore, the output gap r
t
is obtained as follows:
0
G
q
t
0
1
c
t
j
)
t
= 0
G
_
1
1
1
t

t+1
1
2
c
t
1
3

i
t
1
4
:
t
1
5
1
t
c
t+1
_
0
1
c
t
j
)
t

_
0
G
1
t
q
t+1
0
1
1
t
c
t+1
1
t
j
)
t+1
_

_
0
G
1
t
q
t+1
0
1
1
t
c
t+1
1
t
j
)
t+1
_
Rearranging terms:
r
t
= 1
t
r
t+1
0
G
1
1
1
t

t+1
(0
G
1
2
0
1
) c
t
0
G
1
3

i
t
0
G
1
4
:
t
(0
G
1
5
0
1
) 1
t
c
t+1
0
G
1
t
q
t+1
n
t
Replacing the FOC for the central bank in this equation:
A
4
(0
1
j o)
`0
1
1
t

t+1
,A
3
1
t
r
t+2

_
1
1
,
A
2
_
r
t
= 0
G
1
1
1
t

t+1
(0
G
1
2
0
1
) c
t
0
G
1
3

i
t
0
G
1
4
:
t
(0
G
1
5
0
1
) 1
t
c
t+1
0
G
1
t
q
t+1
n
t
Solving once again for the interest rate:

i
t
= 1
1
1
t

t+1
1
2
1
t
r
t+2
1
3
r
t
1
4
c
t
1
5
:
t
1
6
1
t
c
t+1
1
7
1
t
q
t+1
n
t
47
where:
1
0
= (0
G
1
3
)
1
1
1
= 1
0
_
A
4
(0
1
j o)
`0
1
0
G
1
1
_
1
2
= 1
0
,A
3
1
3
= 1
0
_
1
1
,
A
2
_
1
4
= 1
0
(0
G
1
2
0
1
)
1
5
= 1
0
0
G
1
4
1
6
= 1
0
(0
G
1
5
0
1
)
1
7
= 1
0
0
G
n
t
= 1
0
n
t
From the Euler equation and equilibrium in the labor market, it is true that:
c
t
= 1
t
c
t+1

1
o
1
t

t+1

,i
o

i
t
:
t
=
1
1 j
j
t
oc
t
=
1
1 j
_
0
1
o
o
1
t

t+1

0
1
o
o
,i

i
t
(0
1
o) 1
t
c
t+1
0
G
q
t
_
Replacing these relations and solving for the interest rate again, I have that:

i
t
_
1 1
5
,i
1 j
0
1
o
o
1
4
,i
o
_
=
_
1
1

1
4
o

1
5
1 j
0
1
o
o
_
1
t

t+1
1
2
1
t
r
t+2
1
3
r
t

_
1
4

1
5
1 j
(0
1
o) 1
6
_
1
t
c
t+1
1
5
0
G
q
t
1
7
1
t
q
t+1
n
t
This implies:

i
t
= c
1
1
t

t+1
c
2
r
t+2
c
3
r
t
c
4
1
t
c
t+1
c
5
q
t
c
6
1
t
q
t+1
n
t
48
where:
c
0
=
_
1 1
5
,i
1 j
0
1
o
o
1
4
,i
o
_
1
c
1
= c
0
_
1
1

1
4
o

1
5
1 j
0
1
o
o
_
c
2
= c
0
1
2
c
3
= c
0
1
3
c
4
= c
0
_
1
4

1
5
1 j
(0
1
o) 1
6
_
c
5
= c
0
1
5
0
G
1 j
c
6
= c
0
1
7
n
t
= c
0
n
t
49
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52