Eric M. Leeper

Equilibria under 'active' and 'passive' monetary and fiscal policies

Abstract Monetary and fiscal policy interactions are studied in a stochastic maximizing model. Policy is ‘active’ or ‘passive’ depending on its responsiveness to government debt shocks. Schemes for financing deficits and, therefore, the existence and uniqueness of equilibria depend on two policy parameters. The model is used to: (i) characterize the equilibria implied by various financing schemes, (ii) derive policies where fiscal behavior determines how monetary shocks affect prices, and (iii) reinterpret Friedmans 1948 policy framework. The paper reconsiders the result that prices are indeterminate when the nominal interest rate is pegged. The setup can be used to interpret reduced-form studies on fiscal financing.

What Does Monetary Policy Do

This paper uses a single time frame and data set to present and analyze the results that have emerged from the recent empirical literature on the effects of monetary policy. It uses statistical methods that allow the analysis of larger models than appear previously in this literature. Monetary policy actions are shown to be largely systematic responses to the state of the economy. Consequently, there is more uncertainty about the effects of monetary policy than might be thought on the basis of simple graphical or narrative approaches to assessing the evidence. JEL Classifications: E3, E4, E5  1996 by THE BROOKINGS INSTITUTION. This document may be freely reproduced for educational and research purposes provided that i) this copyright notice is included with each copy, ii) no changes are made in the document, and iii) copies are not sold, but retained for individual use or distributed free. 1 Indiana University, Yale University, and Federal Reserve Bank of Atlanta, respectively. A draft of this paper is available by ftp from ftp://ftp.econ.yale.edu/pub/sims/bpea or by http from http://ezinfo.ucs.indiana.edu/~eleeper/home.htm. The authors would like to acknowledge what they have learned about the implementation of monetary policy from conversations with Lois Berthaume, Will Roberds, and Mary Rosenbaum of the Atlanta Fed, Charles Steindel of the New York Fed, Marvin Goodfriend of the Richmond Fed, and Sheila Tschinkel. David Petersen of the Atlanta Fed helped both in locating data and in discussions of the operation of the money markets.

When do long-run identifying restrictions give reliable results?

Many recent articles have identified behavioral disturbances in vector autoregressions by imposing restrictions on the long-run effects of shocks. This article demonstrates that this approach will be unreliable unless the underlying economy satisfies three types of strong restrictions. Although many aspects of these issues have been raised before, this article draws out and illustrates the implications for inferences under the long-run scheme. Furthermore, it provides strategies for dealing with the problems.

The dynamic impacts of monetary policy: an exercise in tentative identification

It is currently popular to identify monetary policy shocks with innovations in some measure of reserves or in the federal funds rate. These assumptions about the interest elasticity of the supply of or demand for reserves imply monetary policy shocks that produce dynamic responses of macroeconomic variables that are anomalous relative to traditional monetary analyses. This paper tentatively identifies supply and demand shocks in the markets for reserves and M2 for the 1980s and contrasts them with results for the 1970s. In the later period, identified monetary policy shocks have dynamic impacts that are fully consistent with traditional analyses.

Fluctuating Macro Policies and the Fiscal Theory

This paper estimates regime-switching rules for monetary policy and tax policy over the post-war period in the United States and imposes the estimated policy process on a calibrated dynamic stochastic general equilibrium model with nominal rigidities. Decision rules are locally unique and produce a stationary long-run rational expectations equilibrium in which (lump-sum) tax shocks always affect output and inflation. Tax non-neutralities in the model arise solely through the mechanism articulated by the fiscal theory of the price level. The paper quantifies that mechanism and finds it to be important in U.S. data, reconciling a popular class of monetary models with the evidence that tax shocks have substantial impacts. Because long-run policy behavior determines existence and uniqueness of equilibrium, in a regime-switching environment more accurate qualitative inferences can be gleaned from full-sample information than by conditioning on policy regime.

Putting 'M' Back in Monetary Policy

Money demand and the stock of money have all but disappeared from monetary policy analyses. This paper is an empirical contribution to the debate over the role of money in monetary policy analysis. The paper models supply and demand interactions in the money market and finds evidence of an essential role for money in the transmission of policy. Across sub-samples, it finds evidence consistent with the following inferences: (1) the money stock and the interest rate jointly transmit monetary policy; (2) for a given exogenous change in the nominal interest rate, the estimated impact of policy on economic activity increases monotonically with the response of the money supply; (3) the path of the real rate is not sufficient for determining policy impacts.

Toward a Modern Macroeconomic Model Usable for Policy Analysis

A macroeconomic model is presented that is both a completely specified dynamic general equilibrium model and a probabilistic model for time series data. We view the model as a potential competitor to the existing IS/LM-based model that continues to be used for actual policy analysis. Our approach is also an alternative to recent efforts to calibrate real business cycle models. In contrast to these existing models, the one we present embodies all the following important characteristics: (1) It generates a complete multivariate stochastic process model for the data it aims to explain, and the full specification is used in the maximum likelihood estimation of the model; (2) it integrates modeling of nominal variables-money stock, price level, wage level, and nominal interest rate-with modeling real variables; (3) it contains a Keynesian investment function, breaking the tight relationship of the return on investment with the capital-output ratio; (4) it treats both monetary and fiscal policy explicitly; and (v) it is based on dynamic optimizing behavior of the private agents in the model. Flexible-price and sticky-price versions of the model are estimated, and their fits are evaluated relative to a naive model of no change in the variables and to an unrestricted vector autoregression (VAR). The models implications for the dynamic responses to structural shocks are displayed, including policy shocks, and evaluates the relative importance of various shocks for determining economic fluctuations.

Clearing Up the Fiscal Multiplier Morass

Bayesian prior predictive analysis of five nested DSGE models suggests that model specifications and prior distributions tightly circumscribe the range of possible government spending multipliers. Multipliers are decomposed into wealth and substitution effects, yielding uniform comparisons across models. By constraining the multiplier to tight ranges, model and prior selections bias results, revealing less about fiscal effects in data than about the lenses through which researchers choose to interpret data. When monetary policy actively targets inflation, output multipliers can exceed one, but investment multipliers are likely to be negative. Passive monetary policy produces consistently strong multipliers for output, consumption, and investment.

Government Investment and Fiscal Stimulus in the Short and Long Runs

This paper contributes to the debate about fiscal multipliers by studying the impacts of government investment in conventional neoclassical growth models. The analysis focuses on two dimensions of fiscal policy that are critical for understanding the effects of government investment: implementation delays associated with building public capital projects and expected future fiscal adjustments to debt-financed spending. Implementation delays can produce small or even negative labor and output responses in the short run; anticipated fiscal financing adjustments matter both quantitatively and qualitatively for long-run growth effects. Taken together, these two dimensions have important implications for the short-run and long-run impacts of fiscal stimulus in the form of higher government infrastructure investment. The analysis is conducted in several models with features relevant for studying government spending, including utility-yielding government consumption, time-to-build for private investment, and government production.

Dynamic Scoring: Alternative Financing Schemes

Neoclassical growth models predict that reductions in capital or labor tax rates are expansionary when lump-sum transfers are used to balance the government budget. This paper explores the consequences of bond-financed tax reductions that bring forth a range of possible offsetting policies, including future government consumption, capital tax rates, or labor tax rates. Through the resulting intertemporal distortions, current tax cuts can be contractionary. The paper also finds that more aggressive responses of offsetting policies to debt engender less debt accumulation and less costly tax cuts.