Optimal Policy with General Signal Extraction

Authors: Esther Hauk, Andrea Lanteri and Albert Marcet

Journal of Monetary Economics, Vol. 118, 54-86, March, 2021

Most available results on optimal decisions under partial information are derived under “separation”. But this principle does not always hold. We derive a non-standard first order condition of optimality from first principles when signal extraction and optimal policy must be jointly determined. This allows us to solve a model of optimal fiscal policy where separation does not apply. Tax smoothing prevails in normal times, but taxes respond strongly in recessions. This non-linearity arises because signal extraction interacts differently with optimal policy depending on the value of the observed signals. Existing results based on the “separation principle” follow as special cases.

This paper originally appeared as Barcelona School of Economics Working Paper 932