The paper considers the coordination of monetary and fiscal policy for a closed economy with the following properties: a Keynesian short-run, a classical steady state and serially cori'elated price adjustment. Given a set of plausible targets, the system is perfectly controllable in the sense of Aoki (1975) only when it is in the classical long-run equilibrium. The imperfect controllability outside the steady state is due to the inertia in the inflationary process. The paper derives a stabilization program which characterizes the optimal response of policy in light of the price adjustment mechanism. The resulting assignment of instruments is an interesting alteration of Mundell's (1962) formula.
1. Introduction
This essay derives an optimal stabilization program for a model which is Keynesian in the short run, but which has a neoclassical steady state. Excess effective demand or supply may prevail in the short run because prices are not perfectly flexible. Tile paper's main purpose is to consider the implications of the price adjustment process for the efficient stabilization policy. Attention centers on the appropriate response of policy to cost push inflation and to parameters which reflect price velocity.
Accordingly, a key factor in the analysis is the price adjustment mechanism. The mechanism used is similar in spirit to the one in Taylor (1978). Price adjustment depends on effective demand and rationally anticipated inflation. Further, there is an element of serial correlation, or inertia, in the process. As a result, systematic deviations from full employment depend on effective demand considerations rather than on expectational errors. ~ At the same time, the sluggish movement of prices permits the model to generate stagflation cycles which are normally associated with adaptive expectations.
An additional aspect of the problem at hand is that the number of targets *An earlier version of this paper was presented at the 7th N.B.E.R. Conference on Economic and Control and at the Columbia University Money Workshop. I would like to acknowledge the helpful comments of Masano Aoki, Willem Buiter, Philip Cagan and the referees.
~lt is well known, due to Fischer (1977) and Phelps andTaylor (1977), that rational expectations does not preclude the effectiveness of stabilizing monetary rules when prices are imperfectly flexible.