Monetary and Fiscal Policy Switching

Abstract

Abstract. A growing body of evidence finds that policy reaction functions vary substantially over different periods in the United States. This paper explores how moving to an environment in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of policy shocks. In one regime monetary policy follows the Taylor principle and taxes rise strongly with debt; in another regime the Taylor principle fails to hold and taxes are exogenous. An example shows that a unique bounded non-Ricardian equilibrium exists in this environment.A computational model illustrates that because agents' decision rules embed the probability that policies will change in the future, monetary and tax shocks always produce wealth effects. When it is possible that fiscal policy will be unresponsive to debt at times, active monetary policy (like a Taylor rule) in one regime is not sufficient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks. The paper also considers the implications of policy switching for two empirical issues.

Monetary-Fiscal Policy Interactions and Fiscal Stimulus

“…2 Work along these lines is more limited, but includes Leeper and Zha (2003), Davig and Leeper (2006), Chung, Davig, and Leeper (2007), and Davig and Leeper (2007), Svensson andWilliams (2007, 2008), Bianchi (2009), andFarmer, Zha, andWaggoner (2009)…”

The fiscal theory of the price level in a world of low interest rates

“…In such richer environments, the validity of the FTPL would depend on the frequency and duration of low-rate episodes, in ways that could be analyzed using a regime-switching model such as Chung, Davig, and Leeper [8] and Davig and…”

Fiscal activism and the cost of debt financing

“…Formally, the fiscal policy rule is presented as follows: where the target deficit consists of a cyclically adjusted target deficit, , and a term allowing for the counter‐cyclical component of fiscal policy, , assumed proportional to the output gap. Importantly, we allow for regime dependence in the policy rule (see also Davig, 2004; Davig and Leeper, 2005; and Chung et al ., 2007). The regime dependence follows from the dependence of the parameters in the policy rule on the regime variable The regime variable s t is assumed to follow the first‐order Markov process with transition matrix P , whose element is : …”