Advanced Search
MyIDEAS: Login to save this paper or follow this series

Stabilizing expectations under monetary and fiscal policy coordination

Contents:

Author Info

  • Stefano Eusepi
  • Bruce Preston

Abstract

This paper analyzes how the formation of expectations constrains monetary and fiscal policy design. Economic agents have imperfect knowledge about the economic environment and the policy regime in place. Households and firms learn about the policy regime using historical data. Regime uncertainty substantially narrows, relative to a rational expectations analysis of the model, the menu of policies consistent with expectations stabilization. When agents are learning about the policy regime, there is greater need for policy coordination: the specific choice of monetary policy limits the set of fiscal policies consistent with macroeconomic stability - and simple Taylor-type rules frequently lead to expectations-driven instability. In contrast, non-Ricardian fiscal policies combined with an interest rate peg promote stability. Resolving uncertainty about the prevailing monetary policy regime improves stabilization policy, enlarging the menu of policy options consistent with stability. However, there are limits to the benefits of communicating the monetary policy regime: the more heavily indebted the economy, the greater is the likelihood of expectations-driven instability. More generally, regardless of agents' knowledge of the policy regime, when expectations are anchored in the long term, short-term dynamics display greater volatility than under rational expectations.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.newyorkfed.org/research/staff_reports/sr343.html
Download Restriction: no

File URL: http://www.newyorkfed.org/research/staff_reports/sr343.pdf
Download Restriction: no

Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 343.

as in new window
Length:
Date of creation: 2008
Date of revision:
Handle: RePEc:fip:fednsr:343

Contact details of provider:
Postal: 33 Liberty Street, New York, NY 10045-0001
Email:
Web page: http://www.newyorkfed.org/
More information through EDIRC

Order Information:
Email:
Web: http://www.ny.frb.org/rmaghome/staff_rp/

Related research

Keywords: Fiscal policy ; Monetary policy ; Rational expectations (Economic theory) ; Taylor's rule ; Economic stabilization ; Financial stability;

Other versions of this item:

Find related papers by JEL classification:

This paper has been announced in the following NEP Reports:

References

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.:
as in new window
  1. Marcet, Albert & Sargent, Thomas J, 1989. "Convergence of Least-Squares Learning in Environments with Hidden State Variables and Private Information," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 97(6), pages 1306-22, December.
  2. Rochelle M. Edge & Jeremy B. Rudd, 2002. "Taxation and the Taylor principle," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2002-51, Board of Governors of the Federal Reserve System (U.S.).
  3. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
  4. Leith, Campbell & von Thadden, Leopold, 2006. "Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers," Discussion Paper Series 1: Economic Studies 2006,21, Deutsche Bundesbank, Research Centre.
  5. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1908, C.E.P.R. Discussion Papers.
  6. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 109(3), pages 659-84, August.
  7. George W. Evans & Seppo Honkapohja, 2006. "Monetary Policy, Expectations and Commitment," Scandinavian Journal of Economics, Wiley Blackwell, Wiley Blackwell, vol. 108(1), pages 15-38, 03.
  8. James Bullard & Kaushik Mitra, 2007. "Determinacy, Learnability, and Monetary Policy Inertia," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 39(5), pages 1177-1212, 08.
  9. John H. Cochrane, 1998. "A Frictionless View of U.S. Inflation," CRSP working papers 479, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  10. Branch, William A. & Davig, Troy & McGough, Bruce, 2013. "Adaptive Learning In Regime-Switching Models," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 17(05), pages 998-1022, July.
  11. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1998-45, Board of Governors of the Federal Reserve System (U.S.).
  12. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers, Department of Economics, University of York 00/41, Department of Economics, University of York.
  13. Benhabib, J. & Schmitt-Grohe, S. & Uribe, M., 1998. "Monetary Policy and Multiple Equilibria," Working Papers, C.V. Starr Center for Applied Economics, New York University 98-02, C.V. Starr Center for Applied Economics, New York University.
  14. McCallum, Bennett T., 1999. "Issues in the design of monetary policy rules," Handbook of Macroeconomics, Elsevier, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 23, pages 1483-1530 Elsevier.
  15. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  16. Nicoletta Batini & Andrew G Haldane, 1999. "Forward-looking rules for monetary policy," Bank of England working papers 91, Bank of England.
  17. Eusepi, Stefano, 2007. "Learnability and monetary policy: A global perspective," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(4), pages 1115-1131, May.
  18. Howitt, Peter, 1992. "Interest Rate Control and Nonconvergence to Rational Expectations," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 100(4), pages 776-800, August.
  19. Preston, Bruce, 2008. "Adaptive learning and the use of forecasts in monetary policy," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 32(11), pages 3661-3681, November.
  20. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  21. Evans, George W. & Honkapohja, Seppo, 2007. "Policy Interaction, Learning, And The Fiscal Theory Of Prices," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 11(05), pages 665-690, November.
  22. Stefano Eusepi & Bruce Preston, 2011. "Expectations, Learning, and Business Cycle Fluctuations," American Economic Review, American Economic Association, American Economic Association, vol. 101(6), pages 2844-72, October.
  23. Eusepi, Stefano & Preston, Bruce, 2007. "Central bank communication and expectations stabilization," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue March, pages 1-43.
  24. Jordi Gali & J. David Lopez-Salido & Javier Valles, 2004. "Rule-of-Thumb Consumers and the Design of Interest Rate Rules," NBER Working Papers 10392, National Bureau of Economic Research, Inc.
  25. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1998. "Monetary policy rules in practice Some international evidence," European Economic Review, Elsevier, vol. 42(6), pages 1033-1067, June.
  26. Svensson, Lars E. O., 1998. "Inflation targeting as a monetary policy rule," CFS Working Paper Series 1998/16, Center for Financial Studies (CFS).
  27. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
  28. George W. Evans & Seppo Honkapohja, 2003. "Expectations and the Stability Problem for Optimal Monetary Policies," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 70(4), pages 807-824, October.
  29. Mark Bils & Peter J. Klenow, 2002. "Some Evidence on the Importance of Sticky Prices," NBER Working Papers 9069, National Bureau of Economic Research, Inc.
  30. Bruce Preston, 2003. "Learning about monetary policy rules when long-horizon expectations matter," Working Paper, Federal Reserve Bank of Atlanta 2003-18, Federal Reserve Bank of Atlanta.
  31. Evans, George W. & Honkapohja , Seppo, 2003. "Policy interaction, expectations and the liquidity trap," Research Discussion Papers 22/2003, Bank of Finland.
  32. 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.
  33. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
  34. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
  35. Troy Davig & Eric M. Leeper, 2005. "Fluctuating Macro Policies and the Fiscal Theory," NBER Working Papers 11212, National Bureau of Economic Research, Inc.
  36. Preston, Bruce, 2006. "Adaptive learning, forecast-based instrument rules and monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(3), pages 507-535, April.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Stefano Eusepi & Bruce Preston, 2010. "Central Bank Communication and Expectations Stabilization," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(3), pages 235-71, July.
  2. Carine Bouthevillain & John Caruana & Cristina Checherita & Jorge Cunha & Esther Gordo & Stephan Haroutunian & Amela Hubic & Geert Langenus & Bernhard Manzke & Javier J. Pérez & Pietro Tommasino, 2009. "Pros and Cons of various fiscal measures to stimulate the economy," BCL working papers 40, Central Bank of Luxembourg.
  3. Christopher A. Sims, 2013. "Comment on "Dormant Shocks and Fiscal Virtue"," NBER Chapters, in: NBER Macroeconomics Annual 2013, Volume 28, pages 59-64 National Bureau of Economic Research, Inc.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:fip:fednsr:343. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Amy Farber).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.