We investigate the optimal responses of policy authorities through a model where the fiscal and the monetary policymakers are independent and play strategically. We allow for the presence of two types of consumers: ‘Ricardians’, who trade in the assets market and ‘liquidity constrained’ consumers, who spend all their disposable labor income for consumption. We find that not only the different game structures but mainly the presence of ‘liquidity constrained’ consumers is crucial in determining the optimal responses of policies. In particular, for high enough fractions of liquidity constrained consumers the way policies react to cope with a mark-up shock change significantly and the role of fiscal policy becomes more relevant.
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