Monetary/Fiscal Policy Mix and Agents’ Beliefs
Abstract
We reinterpret post World War II US economic history using an estimated microfounded
model that allows for changes in the monetary/fiscal policy mix. We find that the
fiscal authority was the leading authority in the ‘60s and the ‘70s. The appointment
of Volcker marked a change in the conduct of monetary policy, but inflation dropped
only when fiscal policy accommodated this change two years later. In fact, a disinflationary
attempt of the monetary authority leads to more inflation if not supported by the
fiscal authority. If the monetary authority had always been the leading authority
or if agents had been confident about the switch, the Great Inflation would not have
occurred and debt would have been higher. This is because the rise in trend inflation
and the decline in debt of the ‘70s were caused by a series of fiscal shocks that
are inflationary only when monetary policy accommodates fiscal policy. The reversal
in the debt-to-GDP ratio dynamics, the sudden drop in inflation, and the fall in output
of the early ‘80s are explained by the switch in the policy mix itself. If such a
switch had not occurred, inflation would have been high for another fifteen years.
Regime changes account for the stickiness of inflation expectations during the ‘60s
and the ‘70s and for the break in the persistence and volatility of inflation.
Type
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