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Modelling Monetary and Fiscal Policy in the US: A Cointegration Approach

  • J. James Reade

As governments and economists worldwide reflect on the unprecedented peacetime build-ups of government deficits and debts since 2008 and the Great Recession, the importance of fiscal and monetary policy interactions and their sustainability is key. This involves both thorough theoretical and careful econometric analysis. This paper provides the latter. We use multivariate cointegration methods to investigate monetary and fiscal interactions using the example of the United States since the early 1980s. Using survey data for inflation expectations, we find that monetary policymaking is heavily forward looking, and passive in the sense that it responds to policy rule. Fiscal policy is found to be active in that it does not respond to the fiscal policy rule discovered in the data. Entering into debates on the efficacy of fiscal policy, we find that in the long-term fiscal deficits are very harmful to growth, but in the short run fiscal stimuli can be effective in restoring the economy to equilibrium. The interactions between the two policy spheres appear somewhat limted in that neither policy tool enters the policy rule of the other policy sphere, but the more passive monetary policy does movwe in reaction to fiscal policy movements - the two policy spheres are complementary in that both respond in the same direction to revive and restrain the economy in downturns and boom times respectively.

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Paper provided by Department of Economics, University of Birmingham in its series Discussion Papers with number 11-02.

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Length: 26 pages
Date of creation: Jan 2011
Date of revision:
Handle: RePEc:bir:birmec:11-02
Contact details of provider: Postal: Edgbaston, Birmingham, B15 2TT
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  1. Joseph G. Haubrich, 2009. "A new approach to gauging inflation expectations," Economic Commentary, Federal Reserve Bank of Cleveland, issue Aug.
  2. Hughes Hallett, Andrew, 2005. "In Praise of Fiscal Restraint and Debt Rules. What the Euro Zone Might Do Now," CEPR Discussion Papers 5043, C.E.P.R. Discussion Papers.
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