The Public Finance Approach to Optimal Stabilization Policy

This paper studies optimal macro-economic stabilization policy by developing a version of the canonical New Keynesian model of a closed economy with three main macro-economic distortions: price rigidities, labor-market rigidities and the zero lower bound on nominal interest rates. We derive that optimal fiscal policy implementations should be geared towards solving the underlying market failures, not bang-for-the-buck calculations based on fiscal multipliers. A tax on wealth - coupled to an investment tax credit - is the optimal way to eliminate the ZLB. Furthermore, the first-best solution to involuntary unemployment is to remove the implicit tax ('wedge') on labor as a result of unemployment by means of an explicit subsidy on employment. Optimal business cycle stabilization is Pigouvian and not Keynesian in the New-Keynesian model.