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MONETARY AND FISCAL POLICY INTERACTION: WHAT IS THE ROLE OF THE TRANSACTION COST OF THE TAX SYSTEM IN STABILISATION POLICIES?

Panagiotis Chronis
University of Athens and Bank of Greece

Aspassia Strantzalou
Ministry of Employment and Social Protection, Greece

ABSTRACT

In the theory of monetary and fiscal policy interaction, the assumption of Ricardian households isolates the determinants of fiscal policy instrument from the price stabilization policies carried out by the central bank. One of the main implications of the above mentioned Ricardian assumption is that the fiscal policy does not have any distortionary effect for the economy, i.e. it does not affect the behaviour of the households, supporting that way the fiscal policy’s neutrality. The argument for this view comes if one assumes that fiscal policy has a distortionary effect on the behaviour of the agents. We relax the above non distortionary assumption by assuming that the imposition of the taxes is consistent with a transaction cost of the tax system that underlies the state - tax payer interaction. In this way we develop a channel through which the stability of prices carried out by the independent central bank is, within optimality, also a function of the fiscal policy determinants (the transaction cost, the tax rates and the debt level). The analysis is carried out in a framework of a monetary union, with two different countries. Within this framework, the effectiveness of a numerical fiscal rule is also examined.

Keywords: Monetary and fiscal policy interactions; Transaction cost of the tax system; Probability of re-election; Stability and growth pact

JEL classification: E52; E58; E62; E63; H60

Acknowledgements:
We thank V. Droucopoulos, H. Gibson and Y. Stournaras for their helpful comments. All remaining errors are ours. The views expressed in this paper are those of the authors and do not necessarily reflect the views of the Bank of Greece nor the Greek Ministry of Employment and Social Protection.

Correspondence:

Panagiotis Chronis
Economic Research Department
Bank of Greece
21, E. Venizelos Ave.
102 50 Athens
Tel: +30 210 3202368
email: pchronis@bankofgreece.gr


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