Anchors Away: How Fiscal Policy Can Undermine “Good” Monetary Policy

Slow moving demographics are aging populations around the world and pushing many countries into an extended period of heightened fiscal stress. In some countries, taxes alone cannot or likely will not fully fund projected pension and health care ex- penditures. If economic agents place sufficient probability on the economy hitting its “fiscal limit” at some point in the future—after which further tax revenues are not forthcoming—it may no longer be possible for “good” monetary policy behavior to control inflation or anchor inflation expectations. In the period leading up to the fiscal limit, the more aggressively that monetary policy leans against inflationary winds, the more expected inflation becomes unhinged from the inflation target. Problems con- frontingmonetary policy are exacerbated when policy institutions leave fiscal objectives and targets unspecified and, therefore, fiscal expectations unanchored.

Fiscal Policy and Inflation: Pondering the Imponderables

An asset-pricing perspective on inflation reveals that it depends on current and expected monetary and fiscal policies. There are three ways to carry $1 today into the future: money, bonds, and real assets. That dollar's purchasing power varies inversely with the price level. Expected money growth, tax rates, and government spending directly impinge on these expected rates of return of these assets, and determine the price level and the inflation rate. The paper considers a tax reduction that is financed by new government debt. It examines how alternative responses of current and future policies to the tax cut can imply very different outcomes for inflation.

Assessing simple policy rules: A view from a complete macroeconomic model

Monetary policy analysts looking for a model on which to base decisions may consider two popular approaches-the New Keynesian (NK) and the identified vector autoregression (VAR) approaches. Choosing between the two can be difficult: NK models are stylized and have simple rules while structural VAR models have complex dynamics and loose behavioral interpretations. ; The simpler NK models often produce stark conclusions. For example, NK analyses consistently find that the Federal Reserve's monetary policy has improved markedly in the past two decades compared with the 1960s and 1970s. In contrast, VARs find little instability in the policy parameters or in the dynamic impacts of exogenous shifts in policy. ; Taking the view that NK models are simply restricted VARs, the authors estimate systems of structural equations implied by NK models. They find that these estimated equations vary considerably over different periods. The authors also investigate the role of money by incorporating money (M2) into the NK model; they find that including money substantially alters the model's conclusions about monetary policy. This result conflicts with the NK theoretical assumption that money is irrelevant. ; Both NK models and VARs have their place in policy advising, the authors believe. But they caution that it is treacherous to draw inferences about policy effects solely from policy rules estimated in isolation from a complete macro model.Macroeconomics ; Econometric models ; Monetary policy

Modest policy interventions

The authors present a framework for computing and evaluating linear projections of macro variables conditional on hypothetical paths of monetary policy. A modest policy intervention is a change in policy that does not significantly shift agents' beliefs about policy regime and does not generate quantitatively important expectations-formation effects of the kind Lucas (1976) emphasizes. The framework is applied to an econometric model of U.S. postwar monetary policy behavior. It finds that a rich class of interventions routinely considered by the Federal Reserve are modest and their impacts can be reliably forecast by an accurately identified linear model. Moreover, modest interventions can matter: They may shift the projected paths and probability distributions of macro variables in economically meaningful ways.Monetary policy ; Forecasting ; Vector autoregression

Modest policy interventions

The authors present a theoretical and empirical framework for computing and evaluating linear projections conditional on hypothetical paths of monetary policy. A modest policy intervention does not significantly shift agents' beliefs about policy regime and does not induce the changes in behavior that Lucas (1976) emphasizes. Applied to an econometric model of U.S. monetary policy, the authors find that a rich class of interventions routinely considered by the Federal Reserve is modest and their impacts can be reliably forecast by an identified linear model. Modest interventions can shift projected paths and probability distributions of macro variables in economically meaningful ways.Equilibrium (Economics) ; Monetary policy ; Macroeconomics ; Inflation (Finance) ; Econometric models

Monetary-fiscal policy interactions and fiscal stimulus

Increases in government spending trigger substitution effects both inter- and intra-temporal and a wealth effect. The ultimate impacts on the economy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes create a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between active and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model's predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act's implied path for government spending under alternative monetary-fiscal policy combinations.

What Has Financed Government Debt?

Dynamic rational expectations models imply that the real value of debt in the hands of the public must be equal to the expected present-value of surpluses. We impose this equilibrium condition on an identified VAR and characterize the way in which the present-value support of debt varies across various types of fiscal policy shocks and between fiscal and non-fiscal shocks. The role of expected primary surpluses in supporting innovations to debt depends on the nature of the shock. For some fiscal policy shocks, debt is supported almost entirely by changes in the present-value of surpluses, however, in the case of other fiscal policy shocks, surpluses fail to adjust and instead leave a large role for expected changes in discount rates. Horizons over which debt innovations are financed are long – on the order of fifty years – while present-values calculated up to any finite horizon up to then fluctuate wildly, particularly following government spending and transfer shocks.

Assessing simple policy rules: a view from a complete macro model

We explore two popular approaches to empirical analysis of monetary policy: the New Keynesian and the identified vector autoregression approaches. Stylized models of private behavior coupled with simple rules describing policy behavior characterize New Keynesian work. Vector autoregressions consist of minimally identified dynamic descriptions of private behavior coupled with a detailed rule for policy behavior. The simplicity of New Keynesian models aids in communication but leaves the models’ implications vulnerable. By relating the New Keynesian models to identified vector autoregressions, we explore the differences and similarities in the two approaches and assess some of the key conclusions to emerge from New Keynesian research.Vector autoregression ; Monetary policy ; Forecasting

Endogenous Monetary Policy Regime Change

This paper makes changes in monetary policy rules (or regimes) endogenous. Changes are triggered when certain endogenous variables cross specified thresholds. Rational expectations equilibria are examined in three models of threshold switching to illustrate that (i) expectations formation effects generated by the possibility of regime change can be quantitatively important; (ii) symmetric shocks can have asymmetric effects; (iii) endogenous switching is a natural way to formally model preemptive policy actions. In a conventional calibrated model, preemptive policy shifts agents’ expectations, enhancing the ability of policy to offset demand shocks; this yields a quantitatively significant “preemption dividend.”Markov switching, Taylor rule, expectations formation

Assessing simple policy rules: a view from a complete macroeconomic model

Macroeconomics ; Econometric models