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 and Fiscal Policy Switching

“…Linear methods can fail to capture this correlation, leading the approximations to incorrectly classify existence and uniqueness of equilibrium. Appendices in Davig, Leeper, and Chung (2004) show this in detail for two different linearization methods.…”

Fiscal Policy in the European Monetary Union

“…It is important to recognize that the assumption that …scal policy follows a rule with timeinvariant parameters is an assumption. Even if we found that the response of the primary surplus to lagged debt were too small for both eigenvalues to be within the unit circle, the monetary authority could still control the price level if the government were expected to adjust the primary surplus in the future in some way that di¤ers from the current estimated rule (Davig, Leeper, Chung 2007). However, promises of future changes to resolve current insolvency might not be credible.…”

“…2, indicate that both tests reject the null hypothesis of no cointegration at the 5 percent level. 21 Pedroni's tests provide strong evidence that s it and b it are cointegrated and that s it and y it are also cointegrated.…”

“…Without an additional assumption on …scal policy, determination of whether …scal policy is passive or active is plagued by serious identi…cation problems. Davig, Leeper, and Chung (2007) add the assumption, that …scal policy follows a rule, to the model. 1 Under this assumption, the coe¢ cient on debt can be used to infer whether …scal policy is passive or active.…”

Risk Assessment Under a Nonlinear Fiscal Policy Rule

“…Under a linear rule, the future marginal response of the primary surplus is assumed to be the same as the historical marginal response. Davig et al () argued that there are regime shifts over different periods in the United States. Similarly, Lloyd‐Ellis and Zhu () argued that there was a change in the fiscal policy of the Canadian government in the mid‐1990s when debt was elevated.…”