This paper examines the optimal response of monetary and fi scal 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. While the model has Keynesian features, its policy prescriptions di¤er signi cantly from textbook Keynesian analysis. Moreover, the model suggests that the commonly used "bang for the buck" calculations are potentially misleading guides for the welfare e¤ects of alternative fiscal policies.
This essay discusses the policy debate concerning optimal taxation and the distribution of income. It begins with a brief overview of trends in income inequality, the leading hypothesis to explain these trends, and the distribution of the tax burden. It then considers the normative question of how the tax system should be designed. The conventional utilitarian framework is found to be wanting, as it leads to prescriptions that conflict with many individuals’ moral intuitions. The essay then explores an alternative normative framework, dubbed the Just Deserts Theory, according to which an individual’s compensation should reflect his or her social contribution.