Optimal fiscal and monetary policy with collateral constraints

Abstract

We study the Ramsey optimal fiscal and monetary policy in an economy where banks face collateral constraints. Inflation reduces the net worth of banks and tightens their collateral constraint by revaluing their nominal assets and liabilities. The optimal policy balances tax distortions with the costs of inflation on banks, thereby deviating from perfect tax smoothing. Our quantitative analysis reveals that inflation plays a much smaller role in financing fiscal needs in the optimal policy compared to existing literature. When considering price stickiness and long-term government debt, optimal inflation is modest and persistent, and the role of inflation in fiscal financing increases with the maturity of government debt.