POLICY GAMES, DISTRIBUTIONAL CONFLICTS, AND THE OPTIMAL INFLATION

Abstract

This paper shows that limited asset-market participation (LAMP) generates an extra inflation bias when the fiscal and the monetary authority play strategically. A fully redistributive fiscal policy eliminates the extra inflation bias, but at the cost of reducing Ricardians' welfare. A fiscal authority that redistributes income only partially reduces the inflation bias, but raises government spending. Although a fully conservative monetary policy is necessary to get price stability, it implies a reduction in liquidity-constrained consumers' welfare, in the absence of redistributive fiscal policies. Finally, under a crisis scenario, none of the policy regimes is able to avoid the fall in economic activity when the increase in the fraction of LAMP is coupled with a negative technology shock, whereas optimal policy can avoid recession when it responds to the increase in LAMP proportion alone.