Monetary and Fiscal Policy Switching
AbstractInterest rate rules for monetary policy and tax rules for fiscal policy change stochastically between two regimes. In the first regime monetary policy follows the Taylor principle and taxes rise strongly with increases in the real value of government debt; in the second regime the Taylor principle fails to hold and taxes follow an exogenous stochastic process. Because agents? decision rules embed the probability that policies will change qualitatively in the future, monetary and tax shocks always produce wealth effects, breaking down Ricardian Equivalence. The impacts of monetary policy shocks can also be different because their fiscal implications (and wealth effects) are different when regime can change. If monetary policy adjusts the interest rate at all in response to inflation, then i.i.d. policy shocks propagate for many periods. The paper also addresses two empirical issues. First the 'price puzzle' that plagues monetary VARs is a natural outcome of periods when monetary policy fails to obey the Taylor principle and taxes do not respond to the state of government indebtedness. Second, dynamic correlations between fiscal surpluses and government liabilities, which have been interpreted as consistent with Ricardian Equivalence, can be produced by an underlying equilibrium that is non-Ricardian
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Bibliographic InfoPaper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 274.
Date of creation: 11 Aug 2004
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Monetary-Fiscal Interactions; Regime-Switching;
Other versions of this item:
- Troy Davig & Eric M. Leeper & Hess Chung, 2005. "Monetary and fiscal policy switching," Research Working Paper RWP 05-12, Federal Reserve Bank of Kansas City.
- Hess Chung & Troy Davig & Eric Leeper, 2004. "Monetary and Fiscal Policy Switching," Computing in Economics and Finance 2004 325, Society for Computational Economics.
- Troy Davig & Eric M. Leeper & Hess Chung, 2004. "Monetary and Fiscal Policy Switching," NBER Working Papers 10362, National Bureau of Economic Research, Inc.
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-10-30 (All new papers)
- NEP-CBA-2004-10-30 (Central Banking)
- NEP-MAC-2004-10-30 (Macroeconomics)
- NEP-MON-2004-10-30 (Monetary Economics)
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