Monetary-Fiscal Mix and Inflation Performance: Evidence from the U.S.

IGIER Working Paper No. 234

28 Pages Posted: 4 Jun 2003

See all articles by Carlo A. Favero

Carlo A. Favero

Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)

Tommaso Monacelli

Bocconi University - Department of Economics

Date Written: April 2003

Abstract

There has been a lot of interest recently in developing small scale rule-based empirical macro models for the analysis of monetary policy. These models, based on the conventional view that inflation stabilization should be a concern of monetary policy only, have typically neglected the role of fiscal policy. We start with the evidence that a baseline VAR-augmented Taylor rule can deliver recurrent mispredictions of inflation in the U.S. before 1987. We then show that a fiscal feed-back rule, in which the primary deficit reacts to both the output gap and the government debt, can well characterize the behavior of fiscal policy throughout the sample. However, by employing Markov-switching methods, we find evidence of substantial instability across fiscal regimes. Yet this precisely happens before 1987. We then augment the monetary VAR with a fiscal policy rule and control for the endogenous regime switches for both rules. We find that only over time windows belonging to the pre-1987 period the model based on the two rules can predict the behavior of inflation better than the one based just on the monetary policy rule. After 1987, when fiscal policy is estimated to switch to a regime of fiscal discipline, the monetary-fiscal mix can be appropriately described as a regime of monetary dominance. Over this period a monetary policy rule based model is always a better predictor of the inflation behavior than the one comprising both a monetary and a fiscal rule.

Keywords: Monetary and Fiscal Policy Rules, Markov Switching, Inflation

JEL Classification: C32, E60, E62

Suggested Citation

Favero, Carlo A. and Monacelli, Tommaso, Monetary-Fiscal Mix and Inflation Performance: Evidence from the U.S. (April 2003). IGIER Working Paper No. 234. Available at SSRN: https://ssrn.com/abstract=393820 or http://dx.doi.org/10.2139/ssrn.393820

Carlo A. Favero

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

HOME PAGE: http://www.igier.unibocconi.it\favero

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Tommaso Monacelli (Contact Author)

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

Register to save articles to
your library

Register

Paper statistics

Downloads
192
Abstract Views
1,123
rank
156,780
PlumX Metrics