What is the right balance between US monetary and fiscal policy? Explorations using simulated wavelet-based optimal tracking control

Evaluating South African Fiscal and Monetary Policy Trade‐offs Using a Wavelet‐Based Model

“…The model selects parameter weights so that the effectiveness of fiscal stimulation decreases as the difference between the current and initial national debt level increases . Following Kendrick and Shoukry () and Crowley and Hudgins (, ), government tax revenue and transfer payments are passively determined based on a constant net tax rate. This is consistent with evidence that fiscal policy is not driven by simple rules wherein tax rates adjust to output (Kliem and Kriwoluzky, ).…”

“…Using the methods of Crowley and Hudgins (; ; ), let the (*) represent the target for any given variable. The model allows the optimal targets for the state and control variables to grow at distinct quarterly target rates of g (.…”

“…The three terms in the index given by (13) penalises the policymakers for the tracking errors in the final state vector, the state vector in each period, and the control vector. As in Crowley and Hudgins (, ), the state and control vectors can be redefined so that they embed the tracking errors, thus transforming the tracking problem into a regulator problem, where the penalty weighting matrices have sizes as follows:…”

“…Another factor that increases the size of the model is that this system also penalises the government for large changes in spending between periods (due to the use of traditional incremental budgeting, rather than by zero‐based budgeting), and penalises the monetary authorities for unstable interest rates (that occur when there large changes in the interest rates between periods), as in Crowley and Hudgins (, ). The closed‐loop feedback control solution is computed by solving recursive Riccati equations as in Crowley and Hudgins (, ).…”

“…It builds on Kendrick and Shoukry (), which first simulated jointly optimal U.S. fiscal and monetary policy within a closed economy accelerator model. The previous work done on closed economies in Crowley and Hudgins (), Crowley and Hudgins (, ) employed a similar strategy of using a wavelet technique called the Maximal Overlap Discrete Wavelet Transform (MODWT) to obtain the time‐frequency domain cyclical decomposition of quarterly U.S. or euro‐area GDP component data, and then simulated optimal fiscal policy or jointly optimal fiscal and monetary policy.…”