Econometric Modeling and Evaluation of Fiscal-Monetary Policy Interactions

Abstract

How do fiscal and monetary policies interact to determine inflation? The conventional view rests on the Taylor principle, that central banks can control inflation by raising nominal interest rate more than one-for-one with inflation. This principle embeds an implicit assumption that the government always adjusts taxes or spending to assure fiscal solvency. But when the required fiscal adjustments are not assured, as may occur during periods of fiscal stress, monetary policy may no longer be able to determine inflation. Under this alternative view, policy roles are reversed, with fiscal policy determining the price level and monetary policy acting to stabilize debt. Because these two policy regimes imply starkly different policy advice, identifying the prevailing regime is a prerequisite to understanding the macro economy and to making good policy choices.

This dissertation employs econometric modeling and evaluation techniques to examine the empirical implications of the dynamic interactions between post-war U.S. fiscal and monetary policies. Chapter One compares two econometric interpretations of a dynamic macro model designed to study U.S. policy interactions. Two main findings emerge. First, the data overwhelmingly support the conventional view of inflation determination under the prevailing, "strong" econometric interpretation that takes literally all of the model's implications for the data. But this result is susceptible to any potential model misspecification. Second, according to the alternative, "minimal" econometric interpretation that is immune to the difficulties with the strong interpretation, the two views of inflation determination can explain the data about equally well. These findings imply that the apparent statistical support in favor of the conventional view over the alternative in the literature stems largely from the strong interpretation rather than from compelling empirical evidence. Therefore, a prudent policymaker should broaden her perspective beyond any single view on the inflation process.

Chapter Two, joint with Todd B. Walker, develops an analytic function approach to solving generalized multivariate linear rational expectations models. This solution method is shown to provide important insights into equilibrium dynamics of well-known models. Chapter Three further demonstrates the usefulness of this method via a conventional new Keynesian model.