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Monetary and Fiscal Policy Switching

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  • Hess Chung
  • Troy Davig
  • Eric Leeper

Abstract

Interest 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 Info

Paper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 274.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nasm04:274

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Keywords: Monetary-Fiscal Interactions; Regime-Switching;

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  1. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, vol. 4(3), pages 381-99.
  2. John H. Cochrane, 1998. "Long-term Debt and Optimal Policy in the Fiscal Theory of the Price Level," CRSP working papers 478, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  3. Christopher A. Sims, 1992. "Interpreting the Macroeconomic Time Series Facts: The Effects of Monetary Policy," Cowles Foundation Discussion Papers 1011, Cowles Foundation for Research in Economics, Yale University.
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