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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. Lars Svensson & Noah Williams, 2005. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," NBER Working Papers 11733, National Bureau of Economic Research, Inc.
  2. Woodford, Michael, 1995. "Price-level determinacy without control of a monetary aggregate," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 43(1), pages 1-46, December.
  3. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, Oxford University Press, vol. 115(1), pages 147-180.
  4. Troy Davig & Eric M. Leeper & Todd B. Walker, 2010. "Inflation and the Fiscal Limit," NBER Working Papers 16495, National Bureau of Economic Research, Inc.
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  8. Eric M. Leeper, 2010. "Monetary Science, Fiscal Alchemy," NBER Working Papers 16510, National Bureau of Economic Research, Inc.
  9. 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 1060, CESifo Group Munich.
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  12. 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.
  13. Hess Chung & Troy Davig & Eric M. Leeper, 2007. "Monetary and Fiscal Policy Switching," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(4), pages 809-842, 06.
  14. Avinash Dixit & Luisa Lambertini, 2003. "Interactions of Commitment and Discretion in Monetary and Fiscal Policies," Boston College Working Papers in Economics 575, Boston College Department of Economics.
  15. Jesús Fernández-Villaverde & Juan Rubio-Ramírez, 2010. "Macroeconomics and Volatility: Data, Models, and Estimation," NBER Working Papers 16618, National Bureau of Economic Research, Inc.
  16. 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.
  17. 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.
  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. Taeyoung Doh & Troy Davig, 2009. "Monetary Policy Regime Shifts and Inflation Persistence," 2009 Meeting Papers 182, Society for Economic Dynamics.
  20. 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.
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