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BPEA Article

An Exploration of Optimal Stabilization Policy

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Abstract

This paper examines the optimal response of monetary and
fiscal policy to a decline in aggregate demand. The theoretical framework is a
two-period general equilibrium model in which prices are sticky in the short
run and flexible in the long run. Policy is evaluated by how well it raises the
welfare of the representative household. Although the model has Keynesian
features, its policy prescriptions differ significantly from those of textbook
Keynesian analysis. Moreover, the model suggests that the commonly used
“bang for the buck” calculations are potentially misleading guides for the
welfare effects of alternative fiscal policies.

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