There has been a lot of interest recently in developing small-scale rule-based empirical macro models for the analysis of monetary policy. These models, based on the conventional view that inflation stabilization should be a concern of monetary policy only, have typically neglected the role of fiscal policy. We start with the evidence that a baseline VAR-augmented Taylor rule can deliver recurrent mispredictions of inflation in the US before 1987. We then show that a fiscal feedback rule, in which the primary deficit reacts to both the output gap and the government debt, can well characterize the behaviour of fiscal policy throughout the sample. By employing Markov-switching methods, however, we find evidence of substantial instability across fiscal regimes. Yet precisely this happens before 1987. We then augment the monetary VAR with a fiscal policy rule and control for the endogenous regime switches for both rules. We find that in the pre-1987 period the model based on the two rules predict the behaviour of inflation better than the one based just on the monetary policy rule. After 1987, when fiscal policy is estimated to switch to a regime of fiscal discipline, the monetary-fiscal mix can be appropriately described as a regime of monetary dominance. Over this period a monetary policy rule based model is always a better predictor of the inflation behaviour than the one comprising both a monetary and a fiscal rule.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
3887.
Find related papers by JEL classification: C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
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Troy Davig & Eric M. Leeper, 2006.
"Generalizing the Taylor Principle,"
Caepr Working Papers
2006-001, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
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