Taylor Rules Cause Fiscal Policy Ineffectiveness
With the aim of constructing a dynamic general equilibrium model where fiscal policy can operate as a demand management tool, we develop a framework which combines staggered prices and overlapping generations based on uncertain lifetimes. Price stickiness plus lack of Ricardian Equivalence could be expected to make tax cuts, financed by increasing government debt, effective in raising short-run output. Surprisingly, in our baseline model this fails to occur. We trace the cause to the assumption that monetary policy is governed by a Taylor Rule. If monetary policy is instead governed by a money supply rule, fiscal policy effectiveness is restored.
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