Monetary and Fiscal Policy Switching

48 Pages Posted: 24 Mar 2004 Last revised: 26 Oct 2022

See all articles by Troy Davig

Troy Davig

Federal Reserve Bank of Kansas City

Eric M. Leeper

University of Virginia ; Indiana University at Bloomington - Department of Economics; National Bureau of Economic Research (NBER); George Mason University - Mercatus Center

Hess Chung

Indiana University Bloomington - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: March 2004

Abstract

A growing body of evidence finds that policy reaction functions vary substantially over different periods in the United States. This paper explores how moving to an environment in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of policy shocks. In one regime monetary policy follows the Taylor principle and taxes rise strongly with debt; in another regime the Taylor principle fails to hold and taxes are exogenous. An example shows that a unique bounded non-Ricardian equilibrium exists in this environment. A computational model illustrates that because agents' decision rules embed the probability that policies will change in the future, monetary and tax shocks always produce wealth effects. When it is possible that fiscal policy will be unresponsive to debt at times, active monetary policy (like a Taylor rule) in one regime is not sufficient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks. The paper also considers the implications of policy switching for two empirical issues.

Suggested Citation

Davig, Troy and Leeper, Eric Michael and Chung, Hess, Monetary and Fiscal Policy Switching (March 2004). NBER Working Paper No. w10362, Available at SSRN: https://ssrn.com/abstract=516703

Troy Davig

Federal Reserve Bank of Kansas City ( email )

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Eric Michael Leeper (Contact Author)

University of Virginia ( email )

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Indiana University at Bloomington - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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George Mason University - Mercatus Center ( email )

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Hess Chung

Indiana University Bloomington - Department of Economics ( email )

304 Wylie Hall
Bloomington, IN 47405-6620
United States