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Stabilizing Expectations under Monetary and Fiscal Policy Coordination

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  • Stefano Eusepi
  • Bruce Preston

Abstract

This paper analyzes the constraints imposed on monetary and fiscal policy design by expectations formation. 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. 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, even when expectations are anchored in the long term, short-term dynamics display greater volatility than under rational expectations.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14391.

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Date of creation: Oct 2008
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Handle: RePEc:nbr:nberwo:14391

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Cited by:
  1. Stefano Eusepi & Bruce Preston, 2007. "Central Bank Communication and Expectations Stabilization," NBER Working Papers 13259, National Bureau of Economic Research, Inc.
  2. Christopher A. Sims, 2013. "Comment on "Dormant Shocks and Fiscal Virtue"," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 2013, Volume 28, pages 59-64 National Bureau of Economic Research, Inc.
  3. 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, Central Bank of Luxembourg 40, Central Bank of Luxembourg.

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