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Dormant Shocks and Fiscal Virtue

Author

Listed:
  • Leonardo Melosi

    (London Business School)

  • Francesco Bianchi

    (Duke University)

Abstract

We develop a model in which the current behavior of the fiscal and monetary authorities influence 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 policy mix, 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 moving to keep debt on a stable path. Shocks which were dormant under the virtuous policy mix start now manifesting themselves. These changes are initially imperceptible, but they unfold over decades and accelerate as agents get convinced that the fiscal authority will not raise taxes. Dormant fiscal shocks can account for the run-up of inflation in the `70s and the deflationary pressure of the early 2000s. We point out that the currently low long term interest rates and inflation expectations might hide the true risk of inflation faced by the US economy.

Suggested Citation

  • Leonardo Melosi & Francesco Bianchi, 2012. "Dormant Shocks and Fiscal Virtue," 2012 Meeting Papers 44, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:44
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    References listed on IDEAS

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    Cited by:

    1. Caggiano, Giovanni & Castelnuovo, Efrem & Groshenny, Nicolas, 2014. "Uncertainty shocks and unemployment dynamics in U.S. recessions," Journal of Monetary Economics, Elsevier, vol. 67(C), pages 78-92.
    2. repec:tpr:restat:v:100:y:2018:i:1:p:187-202 is not listed on IDEAS
    3. Fan, Jingwen & Minford, Patrick & Ou, Zhirong, 2016. "The role of fiscal policy in Britain's Great Inflation," Economic Modelling, Elsevier, vol. 58(C), pages 203-218.
    4. Richter, Alexander W. & Throckmorton, Nathaniel A., 2015. "The consequences of an unknown debt target," European Economic Review, Elsevier, vol. 78(C), pages 76-96.
    5. Francesco Bianchi & Leonardo Melosi, 2017. "Escaping the Great Recession," American Economic Review, American Economic Association, vol. 107(4), pages 1030-1058, April.
    6. Leonardo Melosi, 2014. "Signaling Effects of Monteray Policy," 2014 Meeting Papers 830, Society for Economic Dynamics.
    7. Wolters Maik H. & Tillmann Peter, 2015. "The changing dynamics of US inflation persistence: a quantile regression approach," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 19(2), pages 161-182, April.
    8. repec:eee:jebusi:v:93:y:2017:i:c:p:46-61 is not listed on IDEAS
    9. Harrison, Richard, 2015. "Estimating the effects of forward guidance in rational expectations models," European Economic Review, Elsevier, vol. 79(C), pages 196-213.
    10. Francesco Bianchi & Leonardo Melosi, 2018. "Constrained Discretion and Central Bank Transparency," The Review of Economics and Statistics, MIT Press, vol. 100(1), pages 187-202, March.
    11. repec:oup:restud:v:84:y:2017:i:2:p:853-884. is not listed on IDEAS
    12. Seonghoon Cho, 2016. "Sufficient Conditions for Determinacy in a Class of Markov-Switching Rational Expectations Models," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 21, pages 182-200, July.
    13. Leonardo Melosi, 2017. "Signalling Effects of Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 84(2), pages 853-884.
    14. Kliem, Martin & Kriwoluzky, Alexander & Sarferaz, Samad, 2016. "Monetary–fiscal policy interaction and fiscal inflation: A tale of three countries," European Economic Review, Elsevier, vol. 88(C), pages 158-184.
    15. Hollmayr, Josef & Matthes, Christian, 2015. "Tales of transition paths: Policy uncertainty and random walks," Discussion Papers 14/2015, Deutsche Bundesbank.
    16. Andrew Foerster & Troy Davig, 2014. "Uncertainty and Fiscal Cliffs," 2014 Meeting Papers 717, Society for Economic Dynamics.
    17. Guido Ascari & Anna Florio & Alessandro Gobbi, 2016. "Monetary and Fiscal Policy Interactions: Leeper (1991) Redux," Economics Series Working Papers 788, University of Oxford, Department of Economics.
    18. Scott R. Baker & Nicholas Bloom, 2013. "Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments," CEP Discussion Papers dp1243, Centre for Economic Performance, LSE.
    19. Peter Claeys & Borek Vasicek, 2017. "Transmission of Uncertainty Shocks: Learning from Heterogeneous Responses on a Panel of EU Countries," Working Papers 2017/13, Czech National Bank, Research Department.
    20. P.Antipa, 2014. "How Fiscal Policy Affects the Price Level: Britain’s First Experience with Paper Money," Working papers 525, Banque de France.
    21. Moises S. Andrade & Tiago Berriel, 2016. "Is There an Output Free Lunch for Fiscal Inationary Policies?," Textos para discussão 650, Department of Economics PUC-Rio (Brazil).
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    More about this item

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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