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.

Endogenous Monetary Policy Regime Change

“…Although particulars vary, a common theme across much of the empirical work on time variation in policy behavior is that changes in policy behavior are exogenous. Recent work embeds Markov switching processes for policy in DSGE models to interpret these empirical findings [Davig, Leeper, and Chung (2004), Davig and Leeper (2006a,b)]. 1…”

The comovement between monetary and fiscal policy instruments during the post-war period in the U.S.

“…However, the correlation coefficient is close to zero, especially for the observed measure of deficit, when analyzing long-run dynamics (that is, the 20-year window) during the post-Volcker era (after 1984). This latter result can be explained by the priority shift in fiscal policy toward long-run budget balancing as from the mid-eighties as documented by Davig, Leeper and Chung (2004).…”

“…Many macroeconomists believe that U.S. monetary policy changed to a strong anti-inflationary regime when Paul Volcker became Fed chairman in late 1979. 1 Similarly, as documented by Davig, Leeper and Chung (2004), fiscal policy has exhibited pendulum swings where periods characterized by tight fiscal policy aiming at budget balancing (i.e. a "passive" fiscal policy) are followed by periods characterized by a countercyclical fiscal policy (i.e.…”

“…Using a theoretical approach, Davig, Leeper and Chung (2004) study how the presence of switching-regimes in fiscal and monetary policies changes the effects of economic policy. At the empirical level, by using an augmented VAR specification, Favero and Monacelli (2003) show evidence of monetary and fiscal policy regime shifts in the U.S. and of how the analysis of a monetaryfiscal policy mix helps to explain U.S. inflation dynamics.…”

“…First, the postVolcker period is characterized by a stable regime (say, state 1) featuring 3 The Fed funds rate is taken from FRED (http://research/stlouisfed.org/fred2/). Output gap is calculated as the natural log of the ratio between real gross domestic product (GDPC96, seasonally adjusted) provided by the U.S. Department of Commerce, Bureau of Economic Analysis and real potential gross domestic product (GDPPOT) provided by the U.S. Congress: Congressional Budget Office.…”