Troy Davig

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.

Monetary Policy Regime Shifts and Inflation Persistence

This paper reports the results of estimating a Markov-Switching New Keynesian (MSNK) model using Bayesian methods. The broadest and best fitting MSNK model is a four-regime model allowing independent changes in the regimes governing monetary policy and the volatility of the shocks. We use the estimates to investigate the mechanisms that lead to a decline in the persistence of inflation. We show that the population moment describing the serial correlation of inflation is a weighted average of the autocorrelation parameters of the exogenous shocks. Changes in the monetary or shock volatility regimes shift weight over these serial correlation parameters and affect the serial correlation properties of inflation. Estimation results indicate that a shift to a monetary regime that reacts more aggressively to inflation reduces the weight on the more persistent shocks, so lowers inflation persistence. Similarly, a shift to the low-volatility regime reduces the weight on the more persistent shocks and also contributes to reducing inflation persistence. Estimates of model-implied inflation persistence indicate that it began rising in the late 1960s and peaked around the Volcker disinflation. The subsequent decline in persistence is due to both a more aggressive monetary policy regime and less volatile shocks.

Phillips curve instability and optimal monetary policy

This paper assesses the implications for optimal discretionary monetary policy if the slope of the Phillips curve changes. The paper first derives a ‘switching’ Phillips curve from the optimal pricing decision of a monopolistic firm that faces a changing cost of price adjustment. Two states exists, a state with a high cost of price adjustment that generates a ‘flat’ Phillips curve and a low-cost state that generates a relatively ‘steep’ curve. The second aspect of the paper constructs a utility-based welfare criterion. A novel feature of this criterion is that it has a relative weight on output gap deviations that is state dependent, so it changes with the cost of price adjustment. Optimal monetary policy is computed subject to the switching-Phillips curve under both ad-hoc and utility-based welfare criteria. The utility-based criterion instructs monetary policy to disregard the slope of the Phillips curve and keep its systematic actions constant across different states. This stands in contrast to the prescription coming under the ad-hoc criterion, which advises monetary policy to change its systematic behavior according to the slope of the Phillips curve.

Uncertainty and fiscal cliffs

Fiscal uncertainty arises in many forms. Expiring temporary stimulus measures, projections of rapid debt growth, and oscillating political concerns over general levels of taxation are examples that all contribute to fiscal uncertainty. Motivated by anecdotal evidence associated with the US Fiscal-Cliff episode near the end of 2012, we empirically investigate the impact of economic policy uncertainty on investment and employment, especially with regard to the type of investment project. Increases in policy uncertainty lower investment and employment, with some investment dropping immediately and some more gradually, depending upon the ease of installation of types of capital. Based upon this empirical evidence, we then present a DSGE model of expiring tax provisions, and show that the model generates responses to fiscal uncertainty that match key features of the data. The framework captures a few unique elements of fiscal uncertainty. First, fiscal uncertainty is over the average tax rate, rather than a mean-preserving shock to the future tax rate. Second, households obtain information that tax rates may change at a particular date in the future, though whether tax rates do ultimately change is uncertain. As a result, information indicating that a policy change may occur in the future immediately sets in motion partial adjustments toward the new policy. The degree of adjustment households undertake depends on the probability attached to the outcome that actually does result in a change in fiscal policy. Unsuccessful reforms inject noise into the economy and lower the steady state level of the capital stock and output.

Fluctuating Macro Policies and the Fiscal Theory [with Comments and Discussion]

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 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 the qualitative nature of equilibrium, in a regime-switching environment more accurate qualitative inferences can be gleaned from full-sample information than by conditioning on policy regime.

Expectations and Fiscal Stimulus

Increases in government spending trigger substitution effects—both inter- and intra-temporal—and a wealth effect. The ultimate impacts on the econ- omy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes cre- ate a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between ac- tive and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model’s predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act’s implied path for government spending under alternative monetary-fiscal policy combina- tions.

Is Optimal Monetary Policy Always Optimal

No. And not only for the reason you think. In a world with multiple inefficiencies the single policy tool the central bank has control over will not undo all inefficiencies; this is well understood. We argue that the world is better characterized by multiple inefficiencies and multiple policy makers with various objectives. Asking the policy question only in terms of optimal monetary policy effectively turns the central bank into the residual claimant of all policy and gives the other policymakers a free hand in pursuing their own goals. This further worsens the tradeoffs faced by the central bank. The optimal monetary policy literature and the optimal simple rules often labeled flexible inflation targeting assign all of the cyclical policymaking duties to central banks. This distorts the policy discussion and narrows the policy choices to a suboptimal set. We highlight this issue and call for a broader thinking of optimal policies.

Change-Points in U.S. Business Cycle Durations

This paper develops a change-point model that can endogenously detect a structural shift in a time series of durations. The model is applied to NBER data on U.S. business cycle durations for expansions and contractions. There are two primary results. First, the change-point model endogenously detects a shift in the distribution for the phases of the U.S. business cycle around WWII. The pattern of duration dependence for both contractions and expansions correspond to earlier work, such as Diebold and Rudebusch (1990), Sichel (1991) and Zuehlke(2003), that exogenously split the sample at WWII. The second result is that the change-points for expansions and contractions generally occur earlier than WWII when controlling for various factors, such as the duration of the preceding half-cycle, wars and a trend variable. For expansions, the only significant explanatory variable is a trend, resulting in each successive expansions hazard rate uniformly shifting down. For contractions, both a trend and the lagged duration of the preceding expansion are found, when estimated separately, to be significant. Controlling for a trend, contractions no longer exhibit positive duration dependence following the estimated change-point.

State-Dependent Stock Market Reactions to Monetary Policy: 'Bubble' vs. Fundamental States

This paper presents a test of the response of stock prices to Federal Reserve policy shocks using a Markov-switching framework. The framework endogenously identifies two distinct regimes. The first is a state where the S&P 500 index exhibits a significantly negative response to unexpected changes in the target federal funds rate in the thirty-minute window bracketing FOMC announcements, a result consistent with previous work. However, the model identifies a second regime from September 1998 to September 2002, in which the response of stock prices to policy shocks is insignificant and over ten times more volatile relative to the other regime.

Communicating Monetary Policy Rules

Sixty-two countries around the world use some form of inflation targeting as their monetary policy framework, though none of these countries express explicit policy rules. In contrast, models of monetary policy typically assume policy is set through a rule such as a Taylor rule or optimal monetary policy formulation. Central banks often connect theory with their practice by publishing inflation forecasts that can, in principle, implicitly convey their reaction function. We return to this central idea to show how a central bank can achieve the gains of a rule-based policy without publicly stating a specific rule. The approach requires central banks to specify an inflation target, tolerance bands, and economic projections. When inflation moves outside the band, the central bank must also specify a time frame over which inflation will return to within the band. We show how communication about time horizons and tolerance bands can uniquely pin down a policy rule, and highlight how different types of communication can be used to convey different policy rules.