Academic journal article Journal of Money, Credit & Banking

Monetary-Fiscal Policy Interactions under Implementable Monetary Policy Rules

Academic journal article Journal of Money, Credit & Banking

Monetary-Fiscal Policy Interactions under Implementable Monetary Policy Rules

Article excerpt

A FOCUS OF RECENT research is the design of monetary policy rules under particular fiscal policy regimes. In most cases it is assumed that fiscal policy is Ricardian and so it is up to monetary policy to determine prices and inflation. (1) Papers that explicitly model monetary-fiscal interactions and highlight the role fiscal policy plays in price level determination include Leeper (1991) and Woodford (1995). (2) These approaches study the interactions under contemporaneous monetary policy rules; however, some authors have questioned whether rules conditioning on current inflation or output are implementable (McCallum 1999, Clarida, Gali, and Gertler 2000, Orphanides 2001, Benhabib, Schmitt-Grohe, and Uribe 2001).

This paper addresses an important gap in the literature on monetary policy rules. We examine the implications of simple, implementable monetary policy rules in an environment with monetary--fiscal interactions. In particular, we focus on a model where these interactions matter for price-level determination. We assume that monetary policy is characterized by an interest rate rule that is a linear feedback function of either lagged or expected inflation; this extends Leeper (1991), where the nominal interest rate is a function of the contemporaneous rate of inflation.

We find that the alternative policy rules produce new determinacy results. When monetary policy is forward-looking, determinacy obtains provided fiscal policy is active. With a backward-looking interest rate rule, determinacy obtains provided the policy mix is active fiscal/passive monetary. As a corollary, we find that for both forward- and backward-looking rules, determinacy implies that the unique rational expectations equilibrium (REE) is non-Ricardian.

1. THE MODEL

This paper adopts the representative agent endowment economy in Leeper (1991), also employed by Evans and Honkapohja (2007). This model has (linearized) reduced-form equations

[E.sub.t] [[pi].sub.t+l] = [beta] [R.sub.t], (1)

[b.sub.t] = - [[phi].sub.1] [[pi].sub.t] - [[phi].sub.2] [R.sub.t] - [[phi].sub.3] - [R.sub.t-1] + [[beta].sup.1] [b.sub.t-1] - [t.sub.t], (2)

where [[pi].sub.t] is the inflation rate, [b.sub.t] is real bond holdings, [R.sub.t] is the nominal interest rate, and [[tau].sub.t] is lump-sum taxes. Equation (1) is the (linearized) Fisher relation and (2) is the (linearized) intertemporal budget constraint, [beta] is the discount rate, and [[phi].sub.1], [[phi].sub.2], and [[phi].sub.3] are functions of the model's deep parameters. We refer the reader to these other papers for details on the derivations.

We use the flexible-price endowment economy of Leeper (1991) because it is the most parsimonious model capable of illustrating our results. Woodford (1995) and Sims (1994) find that assuming a New Keynesian-type model does not alter the basic qualitative fiscalist result. This is because the essential ingredient for modeling monetary-fiscal policy interaction is the intertemporal budget constraint, which must bind in an REE. (3)

To close the model, we assume that [R.sub.t] and [[tau].sub.t] are simple, implementable reaction functions. We follow Leeper (1991) in assuming that tax policy is set according to

[[tau].sub.t] [gamma] [b.sub.t-1] + [[psi].sub.t]. (3)

Leeper (1991) also assumes a contemporaneous interest rate rule of the form

[[R.sub.t] = [alpha][[pi].sub.t] + [[theta].sub.t], (4)

where [[psi].sub.t] and [[theta].sub.t] are independent (mean-zero) white noise shocks with bounded support. Interest rate rules of this form have been criticized by McCallum (1999) among others as not being implementable. To address this concern, instead we assume that policy is implemented using rules conditional on observable data. Specifically,

[R..sub.t] = [alpha] [E.sub.t] [[pi].sub.t+j] + [[theta].sub.t] j = -1, 1, (5)

which imposes that interest rates are set using either forward- or backward-looking rules. …

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