Working Paper: NBER ID: w14391
Authors: Stefano Eusepi; Bruce Preston
Abstract: This paper analyzes the constraints imposed on monetary and fiscal policy design by expectations formation. Households and firms learn about the policy regime using historical data. Regime uncertainty substantially narrows, relative to a rational expectations analysis of the model, the menu of policies consistent with expectations stabilization. There is greater need for policy coordination: the specific choice of monetary policy limits the set of fiscal policies consistent with macroeconomic stability --- and simple Taylor-type rules frequently lead to expectations-driven instability. In contrast, non-Ricardian fiscal policies combined with an interest rate peg promote stability. Resolving uncertainty about the prevailing monetary policy regime improves stabilization policy, enlarging the menu of policy options consistent with stability. However, there are limits to the benefits of communicating the monetary policy regime: the more heavily indebted the economy, the greater is the likelihood of expectations-driven instability. More generally, regardless of agents' knowledge of the policy regime, even when expectations are anchored in the long term, short-term dynamics display greater volatility than under rational expectations.
Keywords: Monetary Policy; Fiscal Policy; Expectations; Stabilization; Coordination
JEL Codes: E52; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regime uncertainty (D89) | effectiveness of stabilization policies (E63) |
| nature of monetary policy (E52) | feasibility of fiscal policy options (E62) |
| type of monetary policy (E63) | available fiscal policy choices (E62) |
| clarity in policy communication (E61) | effectiveness of stabilization strategies (E63) |
| use of simple policy rules (E61) | potential for instability in the economy (E32) |