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Monetary-Fiscal Mix and Inflation Performance: Evidence from the U.S

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Carlo A. Favero
Tommaso Monacelli

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Abstract

There has been a lot of interest recently in developing small scale rule-based empirical macro models for the analysis of monetary policy. These models, based on the conventional view that inflation stabilization should be a concern of monetary policy only, have typically neglected the role of fiscal policy. We start with the evidence that a baseline VAR-augmented Taylor rule can deliver recurrent mispredictions of inflation in the U.S. before 1987. We then show that a fiscal feed-back rule, in which the primary deficit reacts to both the output gap and the government debt, can well characterize the behavior of fiscal policy throughout the sample. However, by employing Markov-switching methods, we find evidence of substantial instability across fiscal regimes. Yet this precisely happens QTR{it}{before 1987}. We then augment the monetary VAR with a fiscal policy rule and control for the endogenous regime switches for both rules. We find that only over time windows belonging to the pre-1987 period the model based on the two rules can predict the behavior of inflation better than the one based just on the monetary policy rule. QTR{it}{After 1987}, when fiscal policy is estimated to switch to a regime of fiscal discipline, the monetary-fiscal mix can be appropriately described as a regime of monetary dominance. Over this period a monetary policy rule based model is always a better predictor of the inflation behavior than the one comprising both a monetary and a fiscal rule.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 234.

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Date of creation: 2003
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Handle: RePEc:igi:igierp:234

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  1. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers 1908, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  2. John B. Taylor, 1995. "Monetary policy implications of greater fiscal discipline," Proceedings, Federal Reserve Bank of Kansas City, pages 151-170. [Downloadable!]
  3. Rudebusch, Glenn D, 2005. "Assessing the Lucas Critique in Monetary Policy Models," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(2), pages 245-72, April.
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  4. Ben S. Bernanke & Ilian Mihov, 1998. "Measuring Monetary Policy," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 869-902, August. [Downloadable!] (restricted)
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  5. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
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  6. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February. [Downloadable!] (restricted)
  7. John B. Taylor, 2000. "Reassessing Discretionary Fiscal Policy," Journal of Economic Perspectives, American Economic Association, vol. 14(3), pages 21-36, Summer. [Downloadable!] (restricted)
  8. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Favero, C. & Hendry, D., 1990. "Testing The Lucas Critique: A Review," Economics Series Working Papers 99101, University of Oxford, Department of Economics.
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  10. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Monetary Policy and Multiple Equilibria," American Economic Review, American Economic Association, vol. 91(1), pages 167-186, March. [Downloadable!] (restricted)
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  11. Timothy Cogley & Thomas Sargent, . "Evolving Post-World War II U.S. Inflation Dynamics," Working Papers 2132872, Department of Economics, W. P. Carey School of Business, Arizona State University. [Downloadable!]
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  12. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  13. Lawrence J. Christiano & Terry J. Fitzgerald, 2000. "Understanding the Fiscal Theory of the Price Level," NBER Working Papers 7668, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  14. Henning Bohn, 1998. "The Behavior Of U.S. Public Debt And Deficits," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 949-963, August. [Downloadable!] (restricted)
  15. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 2002. "Should the European Central Bank and the Federal Reserve be concerned about fiscal policy?," Proceedings, Federal Reserve Bank of Kansas City, pages 333-389. [Downloadable!]
  16. Matthew Canzoneri & Behzad Diba, 1999. "The Stability and Growth Pact: A Delicate Balance or an Albatross?," Empirica, Springer, vol. 26(3), pages 241-258, September. [Downloadable!] (restricted)
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  1. V. Anton Muscatelli & Patrizio Tirelli & Carmine Trecroci, 2004. " Fiscal and Monetary Policy Interactions in a New Keynesian Model with Liquidity Constraints," CDMA Conference Paper Series 0402, Centre for Dynamic Macroeconomic Analysis. [Downloadable!]
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  2. Anton Muscatelli & Patrizio Tirelli & Carmine Trecroci, 2004. "Can Fiscal Policy Help Macroeconomic Stabilisation? Evidence from a New Keynesian Model with Liquidity Constraints," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  3. Artis, Michael J & Onorante, Luca, 2006. "The Economic Importance of Fiscal Rules," CEPR Discussion Papers 5684, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. Sabina Pogorelec, 2006. "Fiscal and monetary policy in the enlarged European Union," Working Paper Series 655, European Central Bank. [Downloadable!]
  5. Claeys Peter, 2008. "Estimating the effects of fiscal policy under the budget constraint," wp.comunite 0038, Department of Communication, University of Teramo. [Downloadable!]
    Other versions:
  6. Barbara Annicchiarico & Nicola Giammarioli & Alessandro Piergallini, 2006. "Fiscal policy in a monetary economy with capital and finite lifetime," Working Paper Series 661, European Central Bank. [Downloadable!]
  7. António Afonso, 2008. "Ricardian fiscal regimes in the European Union," Empirica, Springer, vol. 35(3), pages 313-334, July. [Downloadable!] (restricted)
    Other versions:
  8. Peter Claeys, 2005. "Policy Mix and Debt Sustainability: Evidence from Fiscal Policy Rules," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  9. Luca Sala, 2004. "The Fiscal Theory of the Price Level: Identifying Restrictions and Empirical Evidence," Working Papers 257, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University. [Downloadable!]
  10. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor principle," Research Working Paper RWP 05-13, Federal Reserve Bank of Kansas City. [Downloadable!]
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  11. V. Anton Muscatelli & Tiziano Ropele & Patrizio Tirelli, 2004. "Macroeconomic Adjustment in the Euro-area: The Role of Fiscal Policy," Working Papers 2005_20, Department of Economics, University of Glasgow, revised May 2005. [Downloadable!]
  12. Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Optimal simple and implementable monetary and fiscal rules," Working Paper 2007-24, Federal Reserve Bank of Atlanta. [Downloadable!]
  13. Anton Muscatelli & Patrizio Tirelli & Carmine Trecroci, 2003. "Fiscal and Monetary Policy Interactions: Empirical Evidence and Optimal Policy Using a Structural New Keynesian Model," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  14. Annicchiarico, Barbara & Giammarioli, Nicola & Piergallini, Alessandro, 2009. "Budgetary Policies in a DSGE Model with Finite Horizons," MPRA Paper 12650, University Library of Munich, Germany. [Downloadable!]
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