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