Working Paper: CEPR ID: DP3887
Authors: Carlo A. Favero; Tommaso Monacelli
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 US before 1987. We then show that a fiscal feedback rule, in which the primary deficit reacts to both the output gap and the government debt, can well characterize the behaviour of fiscal policy throughout the sample. By employing Markov-switching methods, however, we find evidence of substantial instability across fiscal regimes. Yet precisely this 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 in the pre-1987 period the model based on the two rules predict the behaviour 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 behaviour than the one comprising both a monetary and a fiscal rule.
Keywords: Inflation; Markov Switching; Monetary Policy; Fiscal Policy
JEL Codes: C32; E60; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| baseline VAR-augmented Taylor rule (C51) | mispredicts inflation (E31) |
| fiscal feedback rule (E62) | improves predictive power of the model (C52) |
| fiscal policy regime before 1987 (E65) | characterized by instability (C62) |
| fiscal policy regime post-1987 (E65) | characterized by discipline (Y80) |
| monetary policy (E52) | dominates inflation control (E64) |
| neglect of fiscal policy's role (E62) | misleading interpretations of inflation stabilization (E31) |
| fiscal policy regime mismatch (E62) | essential for understanding inflation dynamics (E31) |