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The Comovement between Monetary and Fiscal Policy Instruments during the Post-War Period in the U.S

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  • Vázquez Pérez, Jesús
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    Abstract

    This paper empirically studies the dynamic relationship between monetary and fiscal policies by analyzing the comovements between the Fed funds rate and the primary deficit/output ratio. Simple economic thinking establishes that a negative correlation between Fed rate and deficit arises whenever the two policy authorities share a common stabilization objective. However, when budget balancing concerns lead to a drastic deficit reduction the Fed may reduce the Fed rate in order to smooth the impact of fiscal policy, which results in a positive correlation between these two policy instruments. The empirical results show (i) a significant negative comovement between Fed rate and deficit and (ii) that deficit and output gap Granger-cause the Fed funds rate during the post-Volcker era, but the opposite is not true.

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    File URL: https://addi.ehu.es/bitstream/10810/6681/1/wp2008-06.pdf
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    Bibliographic Info

    Paper provided by University of the Basque Country - Department of Foundations of Economic Analysis II in its series DFAEII Working Papers with number 2008-.06.

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    Date of creation: Apr 2008
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    Handle: RePEc:ehu:dfaeii:2008.06

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    Postal: Dpto. de Fundamentos del Análisis Económico II, = Facultad de CC. Económicas y Empresariales, Universidad del País Vasco, Avda. Lehendakari Aguirre 83, 48015 Bilbao, Spain
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    Keywords: fed rate; deficit; comovement; switching regimes;

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    1. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 115(1), pages 147-180, February.
    2. Giorgio Valente, 2003. "Monetary policy rules and regime shifts," Applied Financial Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 13(7), pages 525-535.
    3. Hess Chung & Troy Davig & Eric Leeper, 2004. "Monetary and Fiscal Policy Switching," Econometric Society 2004 North American Summer Meetings, Econometric Society 274, Econometric Society.
    4. Christopher A. Sims & Tao Zha, 2006. "Were There Regime Switches in U.S. Monetary Policy?," American Economic Review, American Economic Association, American Economic Association, vol. 96(1), pages 54-81, March.
    5. Rudebusch, Glenn D., 2002. "Term structure evidence on interest rate smoothing and monetary policy inertia," Journal of Monetary Economics, Elsevier, Elsevier, vol. 49(6), pages 1161-1187, September.
    6. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 27(1), pages 129-147, February.
    7. Den Haan, Wouter & Sumner, Steven, 2001. "The Comovements between Real Activity and Prices in the G7," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2801, C.E.P.R. Discussion Papers.
    8. Philip Lowe & Luci Ellis, 1997. "The Smoothing of Official Interest Rates," RBA Annual Conference Volume, Reserve Bank of Australia, in: Philip Lowe (ed.), Monetary Policy and Inflation Targeting Reserve Bank of Australia.
    9. Pagan, Adrian, 1984. "Econometric Issues in the Analysis of Regressions with Generated Regressors," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 221-47, February.
    10. den Haan, Wouter J., 2000. "The comovement between output and prices," Journal of Monetary Economics, Elsevier, Elsevier, vol. 46(1), pages 3-30, August.
    11. Pelletier, Denis, 2006. "Regime switching for dynamic correlations," Journal of Econometrics, Elsevier, Elsevier, vol. 131(1-2), pages 445-473.
    12. Giorgio E. Primiceri, 2005. "Time Varying Structural Vector Autoregressions and Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 821-852.
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