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Did the Tail Wag the Dog? Fiscal Policy and the Federal Reserve during the Great Inflation

Author

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  • Thomas A. Lubik

Abstract

It has been argued that the Great Inflation of the 1970s has been caused by a Federal Reserve policy that was not aggressive enough in combatting inflation. This led to a scenario where the U.S. economy operated under an indeterminate equilibrium with sunspot shocks becoming a driving force behind business cycle fluctuations. This paper reassesses this argument by incorporating explicit fiscal policy into an otherwise standard New Keynesian monetary policy model. Even if monetary policy had been passive, an active fiscal policy that raises taxes aggressively would have implied a determinate equilibrium. If fiscal policy was active during that period the Federal Reserve would therefore have implemented the right policy in order to prevent sunspot-driven instability in the U.S. economy. I use the approach developed by Lubik and Schorfheide (2004) for estimating linear rational expectations models allowing for the possibility of indeterminacy. Fiscal policy is introduced via a tax function that responds to outstanding nominal government bonds. I consider both lump-sum and distortionary taxation. I estimate the model allowing for three distinct regimes: a) active monetary and passive fiscal policies, b) passive monetary and active fiscal policies, and c) both policies passive. I then evaluate the relative fit of the specifications using Bayesian model evaluation techniques

Suggested Citation

  • Thomas A. Lubik, 2005. "Did the Tail Wag the Dog? Fiscal Policy and the Federal Reserve during the Great Inflation," Computing in Economics and Finance 2005 309, Society for Computational Economics.
  • Handle: RePEc:sce:scecf5:309
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    Cited by:

    1. Efrem Castelnuovo & Paolo Surico, 2005. "The Price Puzzle and Indeterminacy," Macroeconomics 0507021, EconWPA.
    2. Efrem Castelnuovo & Paolo Surico, 2005. "The Price Puzzle: Fact or Artefact?," Macroeconomics 0505015, EconWPA, revised 19 Jul 2005.

    More about this item

    Keywords

    Monetary and Fiscal Policy; Federal Reserve; Indeterminacy; Bayesian Estimation;

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary 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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