What Monetary Policy Should Be Strict Price Stability When The Government Uses The Supply Side Fiscal Policies?
What monetary policy should be adopted in order to maintain price stability when the government uses the supply side fiscal policies?
II. Brief Introduction
Monetary and fiscal policies today majorly focus on the demand stimulus by incentivizing consumption in order to increase the aggregate demand to achieve higher output. Even though consumption contributes to the major output, purely focusing on the demand side typically only provides a short run solution to economic growth. Supply-side economy, developed in the 1970s, focused on the production, and the promotion of the aggregate supply. Even though supply side policies are usually distinguished from demand side policies, some are actually overlapped. Cutting income taxes, and investment in education, R&D, and infrastructure can be adopted together with expansionary fiscal policy. Then the question comes as: if the government spends money on supply side policies that improve future productivity and potential output, what policy should the central bank follow in order to maintain price stability given this type of fiscal policy?
III. Little Literature Review
Past researchers have studied on the impact of productivity shocks, and supply side policies in designing monetary policies. Krugman (1998) suggested that a drop in future productivity trapped Japan in ZLB. Fernández-Villaverde, Guerrón-Quintana and Rubio-Ramírez (2011) used a two-period New Keynesian model to study the supply side policies at…