TY  - JOUR
AU  - Davig,Troy
AU  - Leeper,Eric M.
AU  - Chung,Hess
TI  - Monetary and Fiscal Policy Switching
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 10362
PY  - 2004
Y2  - March 2004
UR  - http://www.nber.org/papers/w10362
L1  - http://www.nber.org/papers/w10362.pdf
N1  - Author contact info:
Troy Davig
Research Department
Federal Reserve Bank of Kansas City
Kansas City, MO 64198
E-Mail: troy.davig@kc.frb.org

Eric M. Leeper
Department of Economics
304 Wylie Hall
Indiana University
Bloomington, IN  47405
Tel: 812/855-9157
Fax: NA
E-Mail: eleeper@indiana.edu

Hess Chung
Board of Governors of the Federal Reserve
E-Mail: Hess.T.Chung@frb.gov
AB  - A growing body of evidence finds that policy reaction functions vary substantially over different periods in the United States. This paper explores how moving to an environment in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of policy shocks. In one regime monetary policy follows the Taylor principle and taxes rise strongly with debt; in another regime the Taylor principle fails to hold and taxes are exogenous. An example shows that a unique bounded non-Ricardian equilibrium exists in this environment. A computational model illustrates that because agents' decision rules embed the probability that policies will change in the future, monetary and tax shocks always produce wealth effects. When it is possible that fiscal policy will be unresponsive to debt at times, active monetary policy (like a Taylor rule) in one regime is not sufficient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks. The paper also considers the implications of policy switching for two empirical issues.
ER  -