Ebook Policy Mix and Macroeconomic Stability: Evidence and Some Theory
Recently we have witnessed a vivid interest in macroeconomics for the analysis of policy regimes. The state-of-the-art empirical survey by Christiano, Eichenbaum and Evans (2001) on the effects of monetary policy de-emphasizes the role of shocks and focuses the attention on the systematic component of policy in shaping the business cycle. However nearly the whole literature on business cycles and monetary regimes has analyzed monetary policy in complete isolation, and in particular from fiscal policy. The main justification for this approach lies in the theoretically well-rooted paradigm according to which inflation stabilization should be a concern of the monetary authority only. The more independent such authority the more credible and therefore the more successful in achieving the primary goal of reducing and stabilizing inflation. Current analysis of U.S. monetary policy generally acknowledges that 1979 marks the beginning of a new policy regime characterized by a strong anti-inflationary stance.
A different stream of the literature, usually categorized as the fiscal theory of the price level (FTPL henceforth), has challenged this ”conventional view”. In a nutshell such a literature emphasizes that a tough independent central bank is not sufficient to ensure the goal of price stability unless fiscal policy satisfies some compatibility conditions. This interpretation puts at the centerstage the role of the (monetary and fiscal) policy mix in determining the joint dynamics of inflation and output. According to this view the strong anti-inflationary policy pursued in the U.S. with the onset of the Volcker-Greenspan regime would not have sufficed to successfully moderate inflation without the fiscal adjustment that characterized the U.S. economic policy throughout the nineties. In addition, following the analysis of Leeper (1991), Woodford (1996, 2000) shows that a policy-mix mismatch can lead not only to unpleasant inflationary outcomes from more aggressive monetary stances, but also to more unstable macroeconomic conditions driven by sunspot equilibria.
A (mis)match in the policy mix can take alternative forms. This depends on whether the corresponding monetary and fiscal regimes are defined, in the sense of Leeper (1991), as either active or passive. An active policy authority is one that can typically pursue its own goal without any constraint stemming from either consumer’s optimization or need of fiscal solvency (or both). Hence an active monetary policy can aggressively pursue price stability, while an active fiscal policy can adjust the primary deficit unpredictably regardless of the path of the government debt. Leeper poses these definitions within a well-specified class of (linear) policy rules. He shows that stability and uniqueness of a rational expectation equilibrium require monetary policy to be active (passive) and fiscal policy to passive (active). Woodford (1996, 2000) generalizes the characterization of the fiscal policy regimes. He defines as Ricardian a fiscal regime in which the present value government budget constraint (PVGBC henceforth) holds for any path that might have been followed by prices and interest rates along the equilibrium. A passive (active) fiscal policy in the sense of Leeper is therefore Ricardian (Non-Ricardian) in the sense of Woodford. At one extreme of the spectrum, then, stands a strong form of the FTPL, according to which monetary policy is essentially irrelevant for the determination of the price level. This is the interpretation of the inflation dynamics in the U.S. put forward by Cochrane (1998).
Regardless of the stand one eventually chooses to take on the theoretical plausibility of a purely fiscalist view of inflation, one merit of the FTPL approach is to highlight that the conventional view holds under specific assumptions, usually considered innocuous, on the underlying behavior of the fiscal authorities. In this spirit an appropriately defined monetary policy rule requires also an appropriately defined fiscal policy rule. However, and surprisingly enough, very little attention has been devoted so far to study empirically the role that the interaction between monetary and fiscal policy rules may have played in shaping the postwar macroeconomic outcomes.
A number of authors have recently shifted the attention to the specification of fiscal policy in terms of reaction functions. Taylor (1996, 2000a, 2000b) argues that a fiscal rule can be specified for the U.S. by simply relating the measure of the fiscal stance to the deviation of output from its equilibrium level. He finds evidence of a countercyclical pattern of systematic fiscal policy. ”Taylor fiscal rules” do not explicitly allow for a reaction to the evolution of the government debt. Bohn (1998) argues that a century of U.S data reveals a positive correlation between the Government surplus to GDP ratio and the government debt to GDP ratio.
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