Fiscal-Monetary-Interaction | Macro Paper Warehouse

Optimal Taxation of Inflation

Thu, 01 Jan 2026 00:00:00 +0000

This paper analyzes the effectiveness of a tax on inflation policy (TIP)—a fiscal instrument that would require firms to pay a tax proportional to the increase in their prices—as a complement to conventional monetary policy in a New Keynesian framework with multiple sources of inflation. The central result is that combining TIP with conventional monetary policy can implement the first-best allocation in which inflation is zero and the output gap is closed at all times under any path of shocks. Policy instruments should completely specialize: monetary policy should track the neutral rate of interest (addressing demand and productivity shocks by keeping output at its efficient level), while TIP should rise with markup and inflation expectation shocks. Unlike the 1970s view that saw TIP as a substitute for monetary policy, TIP is shown to be a complement. TIP corrects an externality in firms’ pricing decisions without exacerbating relative price distortions. Calibrated simulations suggest a reasonably calibrated TIP could lower the variance of inflation by 45% and of output by 44% relative to a Taylor-rule-only regime.

Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.

In depth

Q1. What is TIP and what externality does it correct?

TIP (tax on inflation policy) is a fiscal instrument that requires firms to pay a tax proportional to the increase in their prices, and it corrects an externality in firms’ pricing decisions created by markup and inflation expectation shocks that cause private and social returns to price increases to diverge. When shocks to markups or inflation expectations create strategic price-setting incentives, firms’ individually optimal price increases exceed the socially optimal level; TIP re-aligns private with social valuations by making price increases costly. The proposal originated with Wallich and Weintraub (1971) and was widely discussed in the 1970s, but was absent from recent policy discourse until this paper revived it in a microfounded framework.

Q2. What is the complete-specialization result?

Monetary policy and TIP should completely specialize: monetary policy should track the neutral rate of interest—varying with aggregate demand and productivity shocks to keep output at its efficient level—while TIP should respond to markup and inflation expectation shocks, addressing the externalities those shocks create in firms’ pricing. This sharp division of labor arises because each instrument is best suited to a different source of inflation: monetary policy’s power lies in aggregate demand management, while TIP directly corrects the pricing externality. Under complete specialization, the first-best allocation with zero inflation and zero output gap can be implemented under any shock path.

Q3. Does TIP exacerbate relative price distortions?

In contrast with price controls, TIP is found not to exacerbate distortions in relative prices, because TIP is linear in price increases and symmetric across firms, so it does not prevent efficient relative price adjustments across sectors. In an extension with sector-specific TFP shocks requiring relative price adjustments, the paper shows analytically (under some conditions) and numerically (more generally) that TIP has no effect on relative prices across sectors. Firms that face negative productivity shocks moderate their price increases, while firms that otherwise would not change prices are incentivized to decrease them to earn a subsidy, keeping the relative price structure broadly intact.

Q4. How large are the stabilization gains from TIP?

Calibrated simulations show that the stabilization gains from using TIP alongside a Taylor rule are substantial: a reasonably calibrated TIP could lower the variance of inflation by 45% and of output by 44%, with gains especially large for markup and inflation expectation shocks. Welfare gains from TIP are smaller for TFP and demand shocks because the reduction in inflation volatility is partially offset by higher output gap volatility. These quantitative results are based on a calibrated New Keynesian model and are presented as illustrative magnitudes rather than precise empirical estimates.

Q5. What equivalent instruments does the paper consider?

The paper shows a formal equivalence between TIP, production/payroll subsidies (the more traditional tools for markup distortions), a feebate (combining a tax on price increases with a rebate to all firms), and a market for inflation permits. Subsidies can also implement the first best but entail large and persistent fiscal costs; the feebate provides incentives without increasing the average tax burden; the market for inflation permits (proposed by Lerner, 1978) minimizes fiscal authority involvement. TIP is distinguished from these alternatives by its directness and its non-distortionary effect on relative prices.

Key concepts

tax on inflation policy (TIP) : a fiscal instrument requiring firms to pay a tax proportional to the increase in their prices, designed to internalize the externality that individual firms’ price increases impose on aggregate inflation; first proposed by Wallich and Weintraub (1971). inflation externality : the divergence between private and social returns to a firm’s price increase created by markup or inflation expectation shocks; private returns include the markup gain, while social costs include the contribution to aggregate inflation, which TIP is designed to correct. complete specialization : the optimal policy regime in which monetary policy exclusively addresses demand and productivity shocks (by tracking the neutral rate) while TIP exclusively addresses markup and inflation expectation shocks; enables the first-best allocation. feebate : an instrument equivalent to TIP that combines a tax on price increases with a rebate distributed to all firms, providing anti-inflation incentives without increasing the average firm tax burden.

A Tale of Two Bailouts and Their Impact on Subprime Consumer Debt

Mon, 01 Jan 0001 00:00:00 +0000

This paper examines the effects of the Troubled Asset Relief Program (TARP) and the Paycheck Protection Program (PPP)—two government bailout programs during the Global Financial Crisis and the COVID-19 crisis, respectively—on subprime consumer debt, using over 11 million credit bureau observations of individual consumer debt combined with banking, bailout, and local market data. TARP and PPP are found to have opposite effects: subprime consumers in markets with more TARP institutions experienced significantly increased debt burdens following the bailouts, while PPP was associated with reduced subprime consumer debt. Both programs are treated as quasi-natural experiments due to their rapid, largely unanticipated assembly. The findings yield policy implications regarding bailout structures and the conditions attached to bailout funds.

Summary based on a working paper version, AI-assisted and human-reviewed. See the linked published article for the authoritative version.

In depth

Q1. What are the two bailout programs studied and why are they treated as natural experiments?

TARP (2008) and PPP (2020) are treated as quasi-natural experiments because they were assembled quickly during crisis conditions and were largely unanticipated, providing relatively exogenous financial shocks to markets based on the presence of eligible institutions, rather than on prior local demand for credit. Both programs had distinct structures and intended targets—TARP aimed at stabilizing financial institutions directly, while PPP aimed at supporting small business payrolls to prevent employment losses—making their differential effects on subprime consumer debt informative about the channels through which bailout design matters.

Q2. How did TARP affect subprime consumer debt and why?

Subprime consumers in markets with more TARP institutions had significantly increased debt burdens following TARP, consistent with a channel in which bank stabilization via TARP relaxed credit supply conditions (especially for lower-quality borrowers) or with a moral hazard channel in which TARP-recipient banks extended credit more aggressively knowing they had government backing. Subprime mortgages played a central role in the buildup to the GFC, growing from 2.5% to 8.4% of mortgage balances outstanding between 2001 and 2007; the finding that TARP increased rather than reduced subprime debt burdens raises concerns about whether bank stabilization programs sufficiently constrain the subsequent lending behavior of recipient institutions.

Q3. How did PPP affect subprime consumer debt and why?

PPP was associated with reduced subprime consumer debt, consistent with a channel in which the payroll support prevented the expected wave of unemployment-driven debt distress and credit score deterioration that would otherwise have converted prime consumers into subprime borrowers during the COVID-19 crisis. Prior to PPP, the COVID-19 recession—with unemployment peaking at 14.7% in April 2020—was expected to cause a ballooning of subprime consumer debt; the failure of this ballooning to materialize and the actual decline in subprime debt is attributed in part to PPP’s employment and income support function.

Q4. What are the policy implications for bailout design?

The opposite effects of TARP (which increased subprime debt) and PPP (which reduced it) yield policy implications for bailout structures and the conditions attached to bailout funds: bailouts directed at banks without explicit restrictions on subsequent lending behavior may inadvertently stimulate the accumulation of high-risk household debt, while bailouts directed at supporting household incomes and employment may reduce systemic credit risk. These findings suggest that the distribution channel of bailout funds (through banks vs. directly to households and employers) has first-order effects on the resulting debt accumulation and credit risk in the household sector.

Key concepts

TARP (Troubled Asset Relief Program) : the 2008 U.S. government program that provided capital injections to financial institutions during the Global Financial Crisis; found in this paper to be associated with increased subprime consumer debt burdens in affected markets. PPP (Paycheck Protection Program) : the 2020 U.S. government program that provided small business loans/grants to support payrolls during the COVID-19 crisis; found in this paper to be associated with reduced subprime consumer debt, opposite to TARP’s effect. subprime consumer debt : obligations of consumers with low credit scores; the paper’s key outcome measure; elevated levels associated with systemic credit risk (as seen in the buildup to the GFC) and used as a barometer of financial vulnerability in the household sector.

Monetary policy trade-offs amid global supply chain disruptions

Mon, 01 Jan 0001 00:00:00 +0000

This paper employs a proxy structural VAR model to examine the effects of global supply chain (GSC) shocks on U.S. macroeconomic variables and the Federal Reserve’s historical response, and evaluates two counterfactual monetary policy rules using the COVID-19 episode. Large fiscal stimulus amplifies inflation while cushioning the output downturn from GSC shocks. Historically, the Fed adopted a loose stance, looking through price surges from supply chain disruptions. The first counterfactual—which stabilizes inflation—entails less accommodation and yields a more favorable inflation-output trade-off, reflecting greater price flexibility and limited output losses. The second counterfactual—which minimizes a dual-mandate loss function—calls for greater initial easing; under inflation targeting (IT) this involves moderate accommodation, while under average inflation targeting (AIT) the looser initial policy generates more persistent inflation and ultimately requires a contractionary response, worsening the trade-off.

Summary based on a working paper version, AI-assisted and human-reviewed. See the linked published article for the authoritative version.

In depth

Q1. What is the empirical strategy?

The paper estimates a proxy structural VAR model that identifies GSC shocks using the news-based Supply Bottleneck Index (SBI) of Burriel et al. (2024) as a proxy, then evaluates the Fed’s historical response to those shocks and two counterfactual policy rules that substitute for the historical stance. The proxy SVAR approach identifies the GSC shock’s impulse response function and then traces the macroeconomic dynamics that would have obtained under alternative policy rules, holding the non-policy shocks at their historical values. The SBI captures sudden decreases in supply chain functioning from natural disasters, geopolitical events, strikes, and pandemics.

Q2. What is the role of fiscal stimulus in amplifying GSC shock effects?

Large fiscal stimulus—such as the U.S. transfers and spending during COVID-19—amplifies the inflationary impact of GSC shocks while cushioning the output downturn; the interaction between supply disruptions and fiscal expansion is thus an important determinant of the inflation-output dynamics. Without the large fiscal stimulus, GSC shocks would generate the standard supply-shock trade-off with less amplified inflation. With stimulus, the combination of higher aggregate demand (from fiscal transfers) and reduced aggregate supply (from GSC disruptions) creates a strongly inflationary environment.

Q3. What does the first counterfactual (inflation-stabilizing policy) show?

The counterfactual that stabilizes inflation requires less monetary accommodation than the historical stance and yields a more favorable inflation-output trade-off, suggesting that the Fed’s historical ’look-through’ approach was suboptimal given the interaction with fiscal stimulus. The intuition is that earlier and firmer monetary tightening in response to GSC-driven inflation would have reduced inflation expectations pass-through and prevented a larger buildup of price pressures, while the output cost of that tighter stance was limited by the greater price flexibility the model identifies in this environment.

Q4. What is the comparison between IT and AIT in the second counterfactual?

The second counterfactual calls for greater initial easing than the historical stance; under inflation targeting (IT) this involves moderate accommodation, while average inflation targeting (AIT) implies an even looser initial policy that generates more persistent inflation and ultimately requires a contractionary response, worsening the inflation-output trade-off relative to IT. The AIT result reflects the design of that framework: making up for periods of below-target inflation with above-target periods creates a commitment to easy policy even when supply-side inflationary pressures are elevated, producing a worse outcome when supply shocks drive inflation above target.

Key concepts

proxy structural VAR : a structural VAR identified using an external instrument (the proxy variable) that is correlated with the structural shock of interest but uncorrelated with other shocks; used here to identify GSC shocks using the Supply Bottleneck Index. global supply chain (GSC) shock : a sudden decrease in the supply provision or functioning of supply chains stemming from adverse events (natural disasters, pandemics, geopolitical events); identified in this paper as acting like supply shocks, lowering output and raising prices. average inflation targeting (AIT) : a monetary policy framework in which the central bank targets the average rate of inflation over time, implying accommodation of below-target periods with above-target periods; shown here to imply looser initial policy and more persistent inflation in response to supply shocks, worsening the trade-off relative to standard IT.