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Many years ago Samuelson (1969) and Merton (1969, 1971) derived the conditions under which optimal portfolio decisions of long-term investors would not be different from those of short-term investors. One important condition is that the investment opportunity set remains constant over time. Among other things this implies that excess returns are not predictable. Interest in long-term portfolio management has been revived now that a growing body of empirical research has documented predictability for various asset returns. Excess stock returns appear related to valuation ratios like the dividend yield, price earnings ratio, and also to inflation and interest rates. Similarly, the term spread is a well-known predictor of excess bond returns.
A growing number of studies explores the implications of the changing investment opportunity set for long-term investors. As an insightful exploratory tool Campbell and Viceira (2005) introduce a ”term structure of the risk-return trade-off”. They use this term structure to show why time-varying expected returns lead to portfolios that depend on the investment horizon. They focus on a long-term investor who has a choice between stocks and long- and short-term bonds.
The objective of this study is to investigate the behaviour of monetary and fiscal authorities in the Euro area. Our main contribution is joint modelling of behaviour of the two authorities. Simultaneous modelling of fiscal and monetary reaction allows both a more precise estimation of the effects of each policy and an investigation of their reciprocal implications.
Moreover, such choice seems of particular relevance when one of the two authorities is subject to an intertemporal budget constraint which links present and future policy choices and therefore present policy choices and their effects on future macroeconomic conditions.
