Optimal Fiscal Policy Instrument under Different Shocks

Abstract

This paper constructs a New Keynesian model to study optimal tax and government spending rules and compares their welfare. The output gap, inflation and the difference between the output gap and the government spending gap all affect welfare. This paper finds that the optimal fiscal policy instruments under technical shock and cost-push shock are government spending and tax, respectively. If the policymaker is only concerned with the output gap and inflation, the optimal fiscal policy rule and actual social welfare loss will change. However, the optimal fiscal policy instruments under technical shock and cost-push shock are still government spending and tax. This paper also finds that an imperfect financial market affects social welfare but does not change the optimal fiscal policy instrument under different shocks.