Ebook Fiscal and Monetary Policy Interactions in a New Keynesian Model with Liquidity Constraints
Despite the existence of a vast literature on the robustness and optimality of monetary policy rules, relatively little attention has been given to the issue of monetary-fiscal policy interactions. A number of papers have examined the interdependence between fiscal and monetary policies using New Keynesian dynamic general equilibrium models, or game-theoretic models, but none of these models have been tested empirically, with the exception of Muscatelli et al. (2003). In this paper we estimate a small econometric model for the Euro area over the sample period 1970-1998, and analyse the performance of monetary rules in the presence of fiscal stabilizers. While the structural model used in this paper has many elements in common with other New Keynesian dynamic stochastic general equilibrium (DSGE) models, our analysis differs in many aspects. First, we extend some current DSGE models to include a wider range of fiscal policy transmission channels. Second, our model is estimated, in contrast to some attempts to calibrate or numerically simulate these models. Third, the focus of our paper is on the way in which inertial policy rules interact with inertia in the structural model due to the presence of non-optimising consumers and firms. Finally, we also examine the behavior of fiscal policies in a basic two-country version of our Euro-area model, in the presence of a monetary union.
Conventional New Keynesian DSGE models (as discussed for instance in Galí, 2003) typically provide a very limited role for fiscal policy. The standard forward-looking IS curve is based on the assumption of "Ricardian" forward looking consumers, who have full access to complete financial markets. This assumption is contradicted by the empirical evidence on the permanent income hypothesis which supports the view that a significant proportion of consumers are non-Ricardian. Moreover, conventional DSGE models cannot rationalize the positive response of consumption to public expenditure shocks. To account for these effects, we adopt the innovation proposed by Galí et al. (2002), who assume that a fraction of households are constrained to consume out of current income. By doing so, we are also able to model the demand effect of other fiscal variables, i.e. taxes and transfers. On the supply side of the economy, to our knowledge existing empirical New Keynesian DSGE models neglect fiscal distortions. In this paper we make a first attempt at estimating the empirical effect of the tax wedge on the Phillips curve in New Keynesian DSGE models.
We use our estimated model to undertake a number of dynamic simulations, examining the responses of the endogenous variables (including the policy instruments) to unanticipated structural and policy shocks.
Finally, we conduct some policy analysis with our estimated models. This allows us to consider whether the introduction of endogenous fiscal policy rules markedly changes the performance of the monetary policy rule. Earlier contributions (Muscatelli et al., 2003) had found that countercyclical fiscal policy can be welfare-reducing in the presence of optimizing monetary policy makers. In contrast to this evidence, by introducing a role for taxation in the DSGE model, we find that automatic stabilizers based on taxation tend to be more efficient than those based on government spending. We also analyze the impact of inertia (persistence) in the fiscal rule and in the structural model on the performance of the monetary and fiscal policy rules, and find that inertial taxation rules tend to be more efficient than inertial government expenditure rules. Finally we confirm the results in Galí et al. (2003) that the presence of rule of thumb consumers tends to create more instability in the model (by increasing the variability of output and inflation following an inflation shock), but also find that automatic stabilizers based on taxation tend to offset the impact of rule-of-thumb consumers.
The rest of this paper is organized as follows. In the next section we briefly survey the existing literature. In Section 3, we outline the structure of our estimated model and the empirical methodology. In Section 4, we report our estimates and examine some dynamic simulations from our estimated models, whereas in Section 5 we examine the performance and interaction of the monetary and fiscal policy rules. In section 6 we present a two country model for monetary and fiscal policies interections. Section 7 concludes.
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