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Dormant Shocks and Fiscal Virtue

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  • Francesco Bianchi
  • Leonardo Melosi

Abstract

We develop a theoretical framework to account for the observed instability of the link between inflation and fiscal imbalances across time and countries. Current policy makers’ behavior ‡influences agents’' beliefs about the way debt will be stabilized. The standard policy mix consists of a virtuous fiscal authority that moves taxes in response to debt and a central bank that has full control over inflation. When policy makers deviate from this Virtuous regime, agents conduct Bayesian learning to infer the likely duration of the deviation. As agents observe more and more deviations, they become increasingly pessimistic about a prompt return to the Virtuous regime and ‡inflation starts drifting in response to a fiscal imbalance. Shocks which were dormant under the Virtuous regime now start manifesting themselves. These changes are initially imperceptible, can unfold over decades, and accelerate as agents' ’beliefs deteriorate. Dormant shocks explain the run-up of US inflation and uncertainty in the ’70s. The currently low long term interest rates and inflation expectations might hide the true risk of inflation faced by the US economy.

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Bibliographic Info

Paper provided by Duke University, Department of Economics in its series Working Papers with number 13-12.

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Length: 44
Date of creation: 2013
Date of revision:
Handle: RePEc:duk:dukeec:13-12

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Postal: Department of Economics Duke University 213 Social Sciences Building Box 90097 Durham, NC 27708-0097
Phone: (919) 660-1800
Fax: (919) 684-8974
Web page: http://econ.duke.edu/

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Keywords: Fiscal Policy; Monetary Policy; Agents’ beliefs; Markov-switching models; Bayesian learning; Infl‡ation;

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References

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Citations

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Cited by:
  1. Alexander W. Richter & Nathaniel A. Throckmorton, 2013. "The Consequences of Uncertain Debt Targets," Auburn Economics Working Paper Series auwp2013-18, Department of Economics, Auburn University.
  2. Tillmann, Peter & Wolters, Maik Hendrik, 2012. "The changing dynamics of US inflation persistence: A quantile regression approach," IMFS Working Paper Series 60, Institute for Monetary and Financial Stability (IMFS), Goethe University Frankfurt.
  3. Davig, Troy A. & Foerster, Andrew T., 2014. "Uncertainty and fiscal cliffs," Research Working Paper RWP 14-4, Federal Reserve Bank of Kansas City.
  4. Bianchi, Francesco & Melosi, Leonardo, 2013. "Escaping the Great Recession," CEPR Discussion Papers 9643, C.E.P.R. Discussion Papers.
  5. Scott R. Baker & Nicholas Bloom, 2013. "Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments," NBER Working Papers 19475, National Bureau of Economic Research, Inc.

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