The identification of fiscal and monetary policy in a structural VAR

Good economic management depends on understanding shocks from monetary policy, fiscal policy and other sources affecting the economy and their subsequent interactions. This paper presents a new methodology to disentangle such shocks in a structural VAR framework. The method combines identification via sign restrictions, cointegration and traditional exclusion restrictions within a system which explicitly models stationary and non-stationary variables and accounts for both permanent and temporary shocks. The usefulness of the approach is demonstrated on a small open economy where policy makers are actively considering the interaction between monetary and fiscal policies.     

Distortionary fiscal policy and monetary policy goals

We reconsider the role of an inflation conservative central banker in a setting with distortionary taxation. To do so, we assume monetary and fiscal policy are decided by independent authorities that do not abide to past commitments. If the two authorities make policy decisions simultaneously, inflation conservatism causes fiscal overspending. But if fiscal policy is determined before monetary policy, inflation conservatism imposes fiscal discipline. These results clarify that in our setting the value of inflation conservatism depends crucially on the timing of policy decisions.     

Government debt and optimal monetary and fiscal policy

How do different levels of government debt affect the optimal conduct of monetary and fiscal policies? And what do these optimal policies imply for the evolution of government debt over time? To provide an answer, this paper studies a standard monetary policy model with nominal rigidities and monopolistic competition and adds to it a fiscal authority that issues nominal non-state contingent debt, levies distortionary labor income taxes and determines the level of public goods provision. Higher government debt levels make it optimal to reduce public spending, so as to dampen the adverse incentive effects of distortionary taxes, but also strongly influence the optimal stabilization response following technology shocks. In particular, higher debt levels give rise to larger risks to the fiscal budget and to tax rates. This makes it optimal to reduce government debt over time. The optimal speed of debt reduction is missed when using first-order approximations to optimal policies, but is shown to be quantitatively significant in a second-order approximation, especially when technology movements are largely unpredictable in nature.     

Optimal fiscal and monetary policy under sticky prices

This paper studies optimal fiscal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing nominal non-state-contingent bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates) the optimal volatility of inflation is near zero. Second, small deviations from full price flexibility induce near random walk behavior in government debt and tax rates. Finally, price stickiness induces deviation from the Friedman rule.     

Compatibility between monetary and fiscal policy under EMU

The debate over the Stability and Growth Pact (SGP) as a part of European Monetary Union, has highlighted the need to assess the extent to which fiscal policies of union members should be constrained as a pre-requisite for price stability within the union. In this paper, we develop a two country open economy model, where each country has overlapping generations of finitely lived consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure stability of the real debt stock is greater when consumers are not infinitely lived. In principle, this allows for some compensating behaviour between governments, but we show that the scope for compensation is limited. The monetary authority can abandon its active targeting of inflation to stabilise the debt of at most one fiscal authority, and any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.     

Anticipated monetary and fiscal policy effects on output

This paper is a test of the LSW proposition. In a Sargent and Wallace model, two different formal money supply mechanisms are incorporated. One is based on the government budget restraint and the other on the Fed's reaction function. Neither is a pure feedback mechanism. The stochastic process of output is a function of the interaction of the monetary and fiscal policy parameters with the models' disturbances. Thus, the question of the LSW proposition comes down to an empirical issue. The models are then estimated by 3SLS. The results are not incompatible with the policy ineffectiveness proposition.     

Further evidence on monetary and fiscal policy coordination

The extent to which fiscal and monetary policies respond to inflation and unemployment and the degree to which policy makers coordinate their policies have important implications for their usefulness as instruments of economic stabilization. Using a framework of minimizing a policy maker's loss function, subject to the state of the economy, this paper tests for the joint determination of monetary and fiscal policies. Our results show that the pre-Reagan/Bush and pre-Volcker/Greenspan eras can be characterized by a noncooperative game between the two policies. For the Reagan/Bush and Volcker/Greenspan regimes, our results are consistent with a cooperative game in which fiscal policy dominates and monetary policy accommodates. Our results also have implications for the possibility of future cooperation by policy makers.Financial support from Southwest Texas State University and DePaul University is gratefully acknowledged.     

Commodity prices and fiscal policy in a commodity exporting economy

This paper analyzes the macroeconomic effects of commodity price shocks on a commodity exporting country. In doing so, we use a DSGE model developed to describe the business cycle in Chile, a copper exporting country. We compare the effects of commodity-price shocks under different fiscal rules. The results show that if the fiscal policy is conducted in a way such that the government saves most of the extra revenues from the higher commodity price, then the macroeconomic effects of a commodity price increase of 10% are an expansion of output below 0.2% and a real exchange appreciation of 0.5%. In contrast, when fiscal policy is highly expansive, the same commodity price increase implies an output expansion above 0.5% and a real exchange rate appreciation of 0.8%. With our model, we also analyze the effects of persistent reduction in the commodity price, the relevance of exchange rate flexibility and the role of imperfect credibility of the fiscal rule.     

Optimal monetary policy for a small open economy

This paper focuses on the design of monetary policy rules for a small open economy. The model features optimizing behavior, general equilibrium and price stickiness. The real exchange rate is shown to affect the firm's real marginal cost, aggregate supply and aggregate demand. The welfare objective depends on the openness of the economy, and the optimal policy rule differs from that which obtains in a closed economy. The inflation versus output gap stabilization trade-off is caused by the real exchange rate. The implied optimal monetary policy regime is domestic inflation target coupled with controlled floating of the real exchange rate.     

Jointly optimal monetary and fiscal policy rules under liquidity constraints

We study the welfare properties of an economy where both monetary and fiscal policies follow simple rules, and where a subset of agents is liquidity constrained. The welfare benefits of optimizing the fiscal rule are far larger than those of optimizing the monetary rule. The optimized fiscal rule implements strong automatic stabilizers that primarily stabilize the income of liquidity-constrained agents, rather than output. Transfers targeted to liquidity-constrained agents are the preferred fiscal instrument. The optimized monetary rule exhibits super-inertia and a weak inflation response. Optimized simple rules perform as well as the optimal policy under the timeless perspective.     

Sectoral labor adjustment and monetary policy in a small open economy

This paper studies the welfare implications of sectoral labor adjustment cost in a two-sector small open economy model with sticky prices. We find that, when the economy faces external shocks, if monetary policy can stabilize the real economy, then sectoral labor market adjustment cost will lead to welfare loss. However, if monetary policy such as fixed exchange rates cannot stabilize real variables, then some degree of labor market friction will improve welfare instead and the gain will be significant. As a result, the welfare gap between flexible exchange rates and fixed exchange rates decreases with sectoral labor market friction. This is because the friction can offset some of the nominal rigidity and become a substitute for monetary policy to stabilize the real economy.     

Optimal climate and fiscal policy in an OLG economy

This paper develops a climate–economy model to study the joint design of optimal climate and fiscal policies in economies with overlapping generations (OLGs). I demonstrate how capital taxation, if optimal, drives a wedge between the market costs of carbon (the net present value of marginal damages using the market interest rate) and the Pigouvian tax (the net present value of marginal damages using the consumption discount rate of successive OLGs). In contrast to deterministic infinitely lived representative agent models, at the optimum, the capital income tax is positive, the carbon price equals the market costs of carbon but it falls short of the Pigouvian tax when (i) preferences are not separable over consumption and leisure; and (ii) labor income taxes cannot be age-dependent. I also show that restrictions on climate change policy provide a novel rationale for positive capital income taxes.     

Even more on monetary policy in a small open economy

It is well known that in a small open economy with full capital mobility and a fixed exchange rate, monetary policy is ineffective in influencing real output (e.g. the works of Fleming [Int. Monetary Fund Staff Pap. 9 (1962) 369.] and Mundell [Can. J. Econ. Polit. Sci. 29 (1963) 475.]). However, Wu [Int. Rev. Econ. Finance 8 (1999) 223.] finds that when the credit channel is added to this model, monetary policy can have real effects under a fixed exchange rate system. This conclusion hinges on the assumption that open market operations have no effect on foreign exchange reserves of the central bank when evaluating how a change in monetary policy affects the loan market. This assumption is incorrect because under a fixed exchange rate regime, the quantity of foreign reserves becomes endogenous in the model. It is shown that when this assumption is relaxed, monetary policy is still ineffective in influencing output under a fixed exchange regime, even with an operative credit channel.     

Cyclicality of fiscal policy and the shadow economy

A survey of recent literature on cyclical properties of fiscal policy reveals that fiscal policy is procyclical in many developing countries whereas it is countercyclical in developed ones. However, there is no consensus on what drives the difference in this specific cyclical property of fiscal policy. Using cross-section and panel data sets for 78 countries we document that procyclicality of fiscal policy is more pronounced in countries with a larger size of the shadow economy. We also show that policies reducing the size of the shadow economy lead to a less (more) procyclical (countercyclical) fiscal response to shocks.     

Strategic monetary and fiscal policy interactions: An empirical investigation

This paper identifies leadership regimes in monetary-fiscal policy interactions in three countries, the UK, the US and Sweden. We specify a small-scale, structural general equilibrium model of an open economy and estimate it using Bayesian methods. We assume that the authorities can act strategically in a non-cooperative policy game, and compare different leadership regimes. We find that the model of fiscal leadership gives the best fit for the UK and Sweden, while in the US the Nash or non-strategic regime dominates. We assess the extent to which policy maker preferences reflect microfounded social preferences.     

货币政策与财政政策的区域产业结构调整效应比较

本文运用1978—2007年东、中、西部的面板数据分析。货币政策和财政政策是否具有区域产业结构调整效应结果显示:第一,财政政策具有产业结构调整效应,而货币政策的产业结构调整效应并不明显。第二,货币政策在对第一和第三产业的效应方面强于财政政策,而财政政策则在对第二产业的效应方面具有优势。第三,货币政策和财政政策对三次产业的效应都存在比较明显的区域效应。第四,在东部地区货币政策和财政政策对第一产业和第二产业的效应相差非常悬殊,而对第三产业的效应则集中在高位;在中部地区货币政策和财政政策对第二产业的效应集中在高位;在西部地区货币政策对第一产业的效应集中在高位,而财政政策对第一产业的效应则集中在低位。     

The macroeconomic effects of fiscal policy in a stochastically growing economy

This paper develops a stochastic model of endogenous growth with productive government expenditure. Herein, we specify the CES production function according to recent empirical evidence. The elasticity of substitution plays a key role in determining macroeconomic performance and the effectiveness of fiscal policy under uncertainty. Results demonstrate that a large elasticity of substitution provides a large expected growth rate and also large volatility of the growth rate. Regarding these effects, the growth-maximizing tax rate and welfare-maximizing tax rate under uncertainty are larger or smaller than those of deterministic economy according to the elasticity of substitution.     

Real wage rigidities and optimal monetary policy in a small open economy

The main objective of the study is to provide a theoretical analysis of optimal monetary policy in a small open economy where households set real wage in a staggered fashion. The introduction of real wage rigidities plays a important role to resolve main shortcomings of the standard new Keynesian small open economy model. The main findings regarding the issue of monetary policy design can be summarized as three fold. First, the optimal policy is to seek to minimize variance of domestic price inflation, real wage inflation, and the output gap if both domestic price and real wage are sticky. Second, controlling CPI inflation directly or indirectly induces relatively large volatility in output gap and other inflations. Therefore, both CPI inflation-based Taylor rule and nominal wage-inflation based Taylor rule are suboptimal. Last, a policy that responds to a real wage inflation is most desirable.