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Monetary and fiscal policy switching

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Author Info
Troy Davig
Eric M. Leeper
Hess Chung

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Abstract

A growing body of evidence finds that policy reaction functions vary substantially over different periods in the United States. This paper explores how moving to an environment in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of policy shocks. In one regime monetary policy follows the Taylor principle and taxes rise strongly with debt; in another regime the Taylor principle fails to hold and taxes are exogenous. An example shows that a unique bounded non-Ricardian equilibrium exists in this environment. A computational model illustrates that because agents' decision rules embed the probability that policies will change in the future, monetary and tax shocks always produce wealth effects. When it is possible that fiscal policy will be unresponsive to debt at times, active monetary policy (like a Taylor rule) in one regime is not sufficient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks. The paper also considers the implications of policy switching for two empirical issues.

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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 05-12.

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Date of creation: 2005
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Handle: RePEc:fip:fedkrw:rwp05-12

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Related research
Keywords: Monetary policy ; Fiscal policy;

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This paper has been announced in the following NEP Reports: References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Cochrane, John H, 2001. "Long-Term Debt and Optimal Policy in the Fiscal Theory of the Price Level," Econometrica, Econometric Society, vol. 69(1), pages 69-116, January.
    Other versions:
  2. 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.
  3. Sims, Christopher A., 1992. "Interpreting the macroeconomic time series facts : The effects of monetary policy," European Economic Review, Elsevier, vol. 36(5), pages 975-1000, June. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. William A. Branch & Troy Davig & Bruce McGough, 2007. "Expectational stability in regime-switching rational expectations models," Research Working Paper RWP 07-09, Federal Reserve Bank of Kansas City. [Downloadable!]
  2. Troy Davig, 2007. "Phillips curve instability and optimal monetary policy," Research Working Paper RWP 07-04, Federal Reserve Bank of Kansas City. [Downloadable!]
  3. Richhild Moessner, . "Optimal discretionary policy in rational expectations models with regime switching," Bank of England working papers 299, Bank of England. [Downloadable!]
  4. Julia Lendvai, 2006. "Inflation dynamics and regime shifts," Working Paper Series 684, European Central Bank. [Downloadable!]
  5. Bartosz Mackowiak, 2006. "Macroeconomic Regime Switches and Speculative Attacks," SFB 649 Discussion Papers SFB649DP2006-025, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
    Other versions:
  6. Ricardo M. Sousa & António Afonso, 2008. "The Macroeconomic Effects of Fiscal Policy," NIPE Working Papers 22/2008, NIPE - Universidade do Minho. [Downloadable!]
    Other versions:
  7. Roger E.A. Farmer & Daniel F. Waggoner & Tao Zha, 2008. "Minimal state variable solutions to Markov-switching rational expectations models," Working Paper 2008-23, Federal Reserve Bank of Atlanta. [Downloadable!]
  8. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor principle," Research Working Paper RWP 05-13, Federal Reserve Bank of Kansas City. [Downloadable!]
    Other versions:
  9. António Afonso & Ricardo M. Sousa, 2009. "The Macroeconomic Effects of Fiscal Policy in Portugal: a Bayesian SVAR Analysis," Working Papers 2009/09, Department of Economics at the School of Economics and Management (ISEG), Technical University of Lisbon.. [Downloadable!]
    Other versions:
  10. Kevin X. D. Huang & Qinglai Meng, 2007. "Capital and macroeconomic instability in a discrete-time model with forward-looking interest rate rules," Working Papers 07-4, Federal Reserve Bank of Philadelphia. [Downloadable!]
  11. Carlo Favero & Tommaso Monacelli, 2005. "Fiscal Policy Rules and Regime (In)Stability: Evidence from the U.S," Working Papers 282, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University. [Downloadable!]
  12. Troy Davig & Eric Leeper, 2006. "Endogenous monetary policy regime change," Research Working Paper RWP 06-11, Federal Reserve Bank of Kansas City. [Downloadable!]
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  13. Luca Benati & Paolo Surico, 2006. "The Great Moderation and the ‘Bernanke Conjecture’," Computing in Economics and Finance 2006 158, Society for Computational Economics. [Downloadable!]
  14. Jess Benhabib, 2009. "A Note on Regime Switching, Monetary Policy, and Multiple Equilibria," NBER Working Papers 14770, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  15. Óscar J. Arce, 2005. "Reflections on fiscalist divergent price-paths," Banco de España Working Papers 0533, Banco de España. [Downloadable!]
  16. Troy Davig & Eric M. Leeper, 2009. "Reply to "Generalizing the Taylor Principle: A Comment"," NBER Working Papers 14919, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  17. Jesús Fernández-Villaverde & Juan F Rubio-Ramírez, 2007. "How Structural Are Structural Parameters?," Levine's Bibliography 843644000000000057, UCLA Department of Economics. [Downloadable!]
    Other versions:
  18. Michael B. Devereux & Woon Gyu Choi, 2005. "Asymmetric Effects of Government Spending: Does the Level of Real Interest Rates Matter?," IMF Working Papers 05/7, International Monetary Fund. [Downloadable!]
    Other versions:
  19. Andreas Thams, 2006. "Fiscal Policy Effects in the European Union," SFB 649 Discussion Papers SFB649DP2006-016, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
  20. Thams, Andreas, 2007. "The Relevance of the fiscal Theory of the Price Level revisited," MPRA Paper 1645, University Library of Munich, Germany. [Downloadable!]
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