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Dormant Shocks and Fiscal Virtue

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  • Francesco Bianchi

    ()
    (Department of Economics, Duke University)

  • Leonardo Melosi

    ()
    (Federal Reserve Bank of Chicago)

Abstract

We develop a theoretical framework to account for the observed instability of the link between inflation and fiscal imbalances across time and countries. Current policy makers’ behavior influences agents’ beliefs about the way debt will be stabilized. The standard policy mix consists of a virtuous fiscal authority that moves taxes in response to debt and a central bank that has full control over inflation. When policy makers deviate from this Virtuous regime, agents conduct Bayesian learning to infer the likely duration of the deviation. As agents observe more and more deviations, they become increasingly pessimistic about a prompt return to the Virtuous regime and inflation starts drifting in response to a fiscal imbalance. Shocks that were dormant under the Virtuous regime now start manifesting themselves. These changes are initially imperceptible, can unfold over decades, and accelerate as agents’ beliefs deteriorate. Dormant shocks explain the run-up of US inflation and uncertainty in the “70s. The currently low long-term interest rates and inflation expectations might hide the true risk of inflation faced by the US economy.

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Bibliographic Info

Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 13-032.

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Length: 45 pages
Date of creation: 01 May 2013
Date of revision:
Handle: RePEc:pen:papers:13-032

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Keywords: Fiscal Policy; Monetary Policy; Inflation; Agents. beliefs; Markov-switching models; Bayesian learning.;

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Citations

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Cited by:
  1. Tillmann, Peter & Wolters, Maik H., 2014. "The changing dynamics of US inflation persistence: A quantile regression approach," Economics Working Papers 2014-09, Christian-Albrechts-University of Kiel, Department of Economics.
  2. Scott R. Baker & Nicholas Bloom, 2013. "Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments," CEP Discussion Papers dp1243, Centre for Economic Performance, LSE.
  3. Alexander W. Richter & Nathaniel A. Throckmorton, 2013. "The Consequences of Uncertain Debt Targets," Auburn Economics Working Paper Series auwp2013-18, Department of Economics, Auburn University.
  4. Davig, Troy A. & Foerster, Andrew T., 2014. "Uncertainty and fiscal cliffs," Research Working Paper RWP 14-4, Federal Reserve Bank of Kansas City.

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