Working Paper: NBER ID: w27540
Authors: Xiaoshan Chen; Eric M. Leeper; Campbell B. Leith
Abstract: We estimate a model in which fiscal and monetary policy behavior arise from the optimizing behavior of distinct policy authorities, with potentially different welfare functions. Optimal time-consistent policy behavior fits U.S. time series at least as well as rules-based behavior. American policies often do not conform to the conventional mix of conservative monetary policy and debt-stabilizing fiscal policy. Even after the Volcker disinflation, policies did not achieve that conventional mix, as fiscal policy did not act to stabilize debt until the mid 1990s. A credible conservative central bank that follows a time-consistent fiscal policy leader would come close to mimicking the cooperative Ramsey policy. Had that strategic policy mix been in place, American might have avoided the Great Inflation. Enhancing cooperation between policy makers without an ability to commit may be detrimental to welfare.
Keywords: monetary policy; fiscal policy; inflation; economic stability; policy interactions
JEL Codes: E31; E32; E52; E61; E62; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal time-consistent policy behavior (D15) | economic outcomes (F61) |
| lack of a credible conservative central bank following a time-consistent fiscal policy (E61) | Great Inflation (E31) |
| strategic policy mix characterized by a Stackelberg leadership model (D43) | economic stability (E63) |
| enhancing cooperation without commitment (C71) | reduced welfare (I38) |
| optimal time-consistent policy behavior fits U.S. time series data (D15) | rules-based behavior (D01) |