Generalizing Determinacy under Monetary and Fiscal Policy Switches: The Case of the Zero Lower Bound
41 Pages Posted: 7 Sep 2019 Last revised: 2 Nov 2020
Date Written: October 15, 2020
In a fixed-regime setting, it is known since Leeper (1991) that both monetary dominance (mix of active monetary and passive fiscal policies) and fiscal dominance (mix of active fiscal and passive monetary policy) regimes yield a determinate unique equilibrium. This paper shows that in a regime-switching context, switches from monetary dominance to fiscal dominance regimes (and vice-versa) render the overall economy indeterminate. We apply our results to the important case of the exit from the zero lower bound (ZLB), where monetary policy is inherently passive. Contrary to the fixed regime prediction, the economy switching between the ZLB in a fiscally led regime and a monetary dominance regime is robustly indeterminate, making the coordination of agents' beliefs hard because both monetary and fiscal policies are overall strongly passive.
Keywords: Regime-Switching, Zero Lower Bound, Determinacy, Fiscal Policy, Discount Factor
JEL Classification: C62, D84, E31, E32, E42, E52, E58, E62, E63
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