Monetary and Fiscal Policy Switching

By Chung, Hess; Davig, Troy et al. | Journal of Money, Credit & Banking, June 2007 | Go to article overview

Monetary and Fiscal Policy Switching


Chung, Hess, Davig, Troy, Leeper, Eric M., Journal of Money, Credit & Banking


Two THEMES RUN through policy analysis: rules determining policy choice are functions of economic conditions; those rules may change over time. The themes reflect the views that actual policy behavior is purposeful, rather than arbitrary, and that good policy adapts to changes in the structure of the economy or to improvements in understanding how policy affects the economy.

A growing body of evidence finds that policy reaction functions vary substantially over different periods in the United States. In light of this evidence of regime shifts, which is reviewed in Section 1, it is surprising that there is little formal modeling of environments where ongoing regime change is stochastic, and the objects subject to change are parameters determining how the economy feeds back to policy choice.

This paper is the first step of a broader research agenda that explores how moving to environments in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of and, more generally, the analysis of monetary and fiscal policies. (1) We consider interest rate rules for monetary policy and tax rules for fiscal policy; the rules switch stochastically between two regimes. In one regime monetary policy follows the Taylor (1993) principle and taxes rise strongly with increases in the real value of government debt; in another regime the Taylor principle fails to hold and taxes follow an exogenous stochastic process. Using convenient specifications of policy rules, Section 2 presents an analytical example which shows that a unique bounded equilibrium exists in this environment; in that equilibrium, lump-sum taxes always have wealth effects.

More standard forms of policy rules require that the model be solved numerically. Sections 3 and 4 lay out a conventional model of monetary-fiscal policy interactions and describe the computational methods used to solve the non-linear model. Section 5 derives the impacts of exogenous changes in monetary and tax policies in a regime-switching environment and contrast those impacts with their fixed-regime counterparts. When regimes switch, agents' decision rules embed the probability that policies will change in the future and, in consequence, monetary and tax shocks always produce wealth effects. Conventional fixed-regime analyses have found that active monetary policy (like a Taylor rule), which is designed to stabilize aggregate demand and inflation, requires that fiscal policy adjust taxes in response to debt. In contrast, when regimes change and it is possible that taxes will be unresponsive to debt at times, active monetary policy in one regime is not sufficient to insulate the economy against tax shocks in that regime, and may have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks.

It turns out that as long as private agents put probability mass on a regime in which taxes respond weakly (or not at all) to debt, lump-sum tax disturbances always generate aggregate demand effects. Section 6 demonstrates this result by considering a range of specifications for the stochastic process governing monetary--fiscal regime.

In Section 7 the paper considers the implications of policy switching for two empirical issues. First, the "price puzzle" that plagues monetary VARs is a natural outcome of periods when monetary policy fails to obey the Taylor principle and taxes do not respond to the state of government indebtedness. Second, dynamic correlations between fiscal surpluses and government liabilities, which have been interpreted as consistent with Ricardian equivalence, can be produced by an underlying equilibrium in which taxes matter.

Regime change is treated as exogenous throughout the paper. By helping with tractability and permitting more straightforward interpretations, this assumption is a reasonable first step. It is also completely consistent with, for example, the massive literature on Taylor (1993) rules for monetary policy, which merely posits simple characterizations of policy behavior with exogenously chosen parameter values. …

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