Policy Regimes, Policy Shifts, and U.S. Business Cycles

52 Pages Posted: 3 Jun 2012 Last revised: 16 Jul 2015

See all articles by Saroj Bhattarai

Saroj Bhattarai

Pennsylvania State University - Department of Economics

Jae Won Lee

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences - New Brunswick/Piscataway - Department of Economics

Woong Yong Park

Seoul National University

Date Written: August 2, 2012

Abstract

Using an estimated DSGE model that features monetary and fiscal policy interactions and allows for equilibrium indeterminacy, we find that a passive monetary and passive fiscal policy regime prevailed in the pre-Volcker period while an active monetary and passive fiscal policy regime prevailed post-Volcker. Since both monetary and fiscal policies were passive pre-Volcker, there was equilibrium indeterminacy that gave rise to self-fulfilling beliefs and resulted in substantially different transmission mechanisms of policy as compared to conventional models: unanticipated increases in interest rates increased inflation and output while unanticipated increases in lump-sum taxes decreased inflation and output. Unanticipated shifts in monetary and fiscal policies however, played no substantial role in explaining the variation of inflation and output at any horizon in either of the time periods. Pre-Volcker, in sharp contrast to post-Volcker, we find that a time-varying inflation target does not explain low-frequency movements in inflation. Finally, in a counterfactual exercise, we show that had the monetary policy regime of the post-Volcker era been in place pre-Volcker, inflation volatility would have been lower by 36% and the rise of inflation in the 1970s would not have occurred.

Keywords: Monetary and fiscal policy regimes, Monetary and fiscal policy transmission; Indeterminacy, Self-fulfilling beliefs, Output, inflation, debt dynamics, Bayesian estimation of DSGE models

JEL Classification: C52, C54, E31, E32, E52, E63

Suggested Citation

Bhattarai, Saroj and Lee, Jae Won and Park, Woong Yong, Policy Regimes, Policy Shifts, and U.S. Business Cycles (August 2, 2012). Available at SSRN: https://ssrn.com/abstract=2073057 or http://dx.doi.org/10.2139/ssrn.2073057

Saroj Bhattarai

Pennsylvania State University - Department of Economics ( email )

Harrisburg, PA
United States

Jae Won Lee

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences - New Brunswick/Piscataway - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

Woong Yong Park (Contact Author)

Seoul National University ( email )

Kwanak-gu
Seoul, 151-742
Korea, Republic of (South Korea)

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