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Policy Rule Coefficients Driven by Latent Factors: Monetary and Fiscal Policy Interactions in an Endowment Economy

  • Gonzalez-Astudillo, Manuel

In this paper I formulate, solve and estimate an endowment version of a macroeconomic dynamic stochastic general equilibrium model with monetary and fiscal policy rules whose coefficients are time-varying and contemporaneously correlated. The aim of the paper is to identify from data the interactions between monetary and fiscal policies that have prevailed in the U.S. economy. The monetary authority uses a Taylor rule and the fiscal authority uses a rule in which taxes respond to lagged debt deviations. Policy rule coefficients are modeled as logistic functions of stationary correlated latent factors, introducing long-run interactions between monetary and fiscal policies. There are three main findings of the paper: First, monetary policy has reacted strongly to inflation deviations along, almost, the entire analyzed period, with a loose policy only during the periods 1979:1-1981:3 and 2008:4-2009:2. Second, regimes under which a determinacy condition is in place occur 54.25% of the time, while regimes with exploding local dynamics occur 45.34% of the time, and there is an association between the duration of these unstable regimes and the volatility of inflation. Third, tightening monetary policy in terms of increasing the reaction of the central bank with respect to inflation deviations, given the situation of the economy in the third quarter of 2010, implies an increase in inflation of the order of 3%.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 29976.

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Date of creation: 30 Mar 2011
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Handle: RePEc:pra:mprapa:29976
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  1. Troy Davig & Eric M. Leeper & Hess Chung, 2005. "Monetary and fiscal policy switching," Research Working Paper RWP 05-12, Federal Reserve Bank of Kansas City.
  2. Svensson, Lars E. O. & Williams, Noah, 2005. "Monetary policy with model uncertainty: distribution forecast targeting," Discussion Paper Series 1: Economic Studies 2005,35, Deutsche Bundesbank, Research Centre.
  3. Troy Davig & Eric Leeper, 2006. "Endogenous monetary policy regime change," Research Working Paper RWP 06-11, Federal Reserve Bank of Kansas City.
  4. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor Principle," NBER Working Papers 11874, National Bureau of Economic Research, Inc.
  5. Troy Davig & Eric M. Leeper, 2007. "Fluctuating Macro Policies and the Fiscal Theory," NBER Chapters, in: NBER Macroeconomics Annual 2006, Volume 21, pages 247-316 National Bureau of Economic Research, Inc.
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  9. Muscatelli, V. Anton & Tirelli, Patrizio & Trecroci, Carmine, 2004. "Fiscal and monetary policy interactions: Empirical evidence and optimal policy using a structural New-Keynesian model," Journal of Macroeconomics, Elsevier, vol. 26(2), pages 257-280, June.
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  13. Taeyoung Doh & Troy Davig, 2009. "Monetary Policy Regime Shifts and Inflation Persistence," 2009 Meeting Papers 182, Society for Economic Dynamics.
  14. Thomas Lubik & Frank Schorfheide, 2002. "Testing for Indeterminacy:An Application to U.S. Monetary Policy," Economics Working Paper Archive 480, The Johns Hopkins University,Department of Economics, revised Jun 2003.
  15. Avinash Dixit & Luisa Lambertini, 2003. "Interactions of Commitment and Discretion in Monetary and Fiscal Policies," American Economic Review, American Economic Association, vol. 93(5), pages 1522-1542, December.
  16. Marco Buti & Werner Roeger & Jan In't Veld, 2001. "Stabilizing Output and Inflation: Policy Conflicts and Co-operation under a Stability Pact," Journal of Common Market Studies, Wiley Blackwell, vol. 39(5), pages 801-828, December.
  17. Leith, Campbell & Wren-Lewis, Simon, 2000. "Interactions between Monetary and Fiscal Policy Rules," Economic Journal, Royal Economic Society, vol. 110(462), pages C93-108, March.
  18. Giorgio E. Primiceri, 2005. "Time Varying Structural Vector Autoregressions and Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 821-852.
  19. Jesus Fernández-Villaverde & Pablo Guerrón-Quintana & Juan F. Rubio-Ramírez, 2010. "Fortune or virtue: time-variant volatilities versus parameter drifting," Working Papers 10-14, Federal Reserve Bank of Philadelphia.
  20. May, Ann Mari, 1990. "President Eisenhower, Economic Policy, and the 1960 Presidential Election," The Journal of Economic History, Cambridge University Press, vol. 50(02), pages 417-427, June.
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