Monetary and Fiscal Policy Switching
A growing body of evidence finds that policy reaction functions vary substantially over diï¬€erent periods in the United States. This paper explores how moving to an environment in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of policy shocks. In one regime monetary policy follows the Taylor principle and taxes rise strongly with debt; in another regime the Taylor principle fails to hold and taxes are exogenous. An example shows that a unique bounded non-Ricardian equilibrium exists in this environment. A computational model illustrates that because agents" decision rules embed the probability that policies will change in the future, monetary and tax shocks always produce wealth eï¬€ects. When it is possible that fiscal policy will be unresponsive to debt at times, active monetary policy (like a Taylor rule) in one regime is not suï¬ƒcient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand eï¬€ects of tax shocks. The paper also considers the implications of policy switching for two empirical issues
|Date of creation:||11 Aug 2004|
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