Optimal fiscal and monetary policy with sticky information

Labor income tax rate smoothing over the business cycle is a key result in the optimal fiscal policy literature. This paper studies the optimality of tax smoothing in a model with sticky information in the production sector, and compares the dynamic responses of the economy to government spending and technology shocks under both sticky information and sticky prices. In this paper, I assume an economy with three types of agents; households, firms and a government. Two different variants for the price setting behavior by firms are considered. In the sticky price model, firms choose their prices optimally through a forward looking behavior. They use all available information when setting prices. On the other hand, in the sticky information model, firms decide their prices under the information constraints. Not all of them obtain the information in the same time and by the same amount. They collect and process the necessary information first, and then they set prices accordingly and gradually.The main finding of the paper is that the introduction of information stickiness causes large fluctuations in the labor income tax rate even if prices are fully flexible; therefore, full smoothing of the labor income tax rate is not optimal. On the other hand, when the degree of information stickiness increases, the volatility of inflation declines. These findings reflect the observation that, in the sticky information model, the cost of obtaining and processing the information makes firms inattentive, which in turn induces stickiness in the behavior of inflation. I also show that a government spending shock generates less volatility in the main variables under sticky information than in sticky price model.