Working Papers,
Copenhagen Business School, Department of Finance

Abstract: The article examines how government spending is determined in a closed economy where the nominal wage is pre-set through contracts and the wage setters have perfect foresight regarding subsequent policy decisions. The monetary regime affects government spending because: (i) with a pre-set nominal wage, a given change in government spending has different effects on employment and inflation under different monetary regimes, and (ii) the authorities’ inclination to expand government spending is affected by the inflation rate which depends on the monetary regime. If the costs related to inflation are high, a comparison between monetary regimes suggests that welfare is highest under nominal income targeting where the nominal income target is determined to bring about price stability.

Keywords: Monetary regimes; fiscal policy; monetary non-neutrality

JEL-codes: E42; E61; E62

23 pages, June 27, 2006

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