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Monetary and Fiscal Policy Switching By Troy Davig, Eric
M. Leeper, and Hess Chung* |
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Abstract A growing body of evidence finds that policy reaction functions vary substantially over different 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 effects. 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 sufficient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks. The paper also considers the implications of policy switching for two empirical issues. Keywords: Monetary Policy, Fiscal Policy, Policy Interactions, Regime Switching JEL classifications: E43, E52, E62, E63 *This version: December 28, 2005. We thank Michael Binder, Chuck
Carlstrom, Betty Daniel, Behzad Diba, Jon Faust, Dale Henderson, Bartosz
Ma´ckowiak, Jim Nason, Giorgio Primiceri, Lars Svensson, Martin Uribe and
seminar participants at Banco de Portugal, Duke University, the Federal
Reserve Bank of Cleveland, the Federal Reserve Board, and the ECB for
helpful comments. Affiliations: Davig, Federal Reserve Bank of Kansas City (Troy.Davig@kc.frb.org);
Leeper, Indiana University and NBER (eleeper@indiana.edu); Chung, Indiana
University (htchung@indiana.edu). The views expressed herein are solely
those of the authors and do not necessarily reflect the views of the Federal
Reserve Bank of Kansas City or the Federal Reserve System.
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