TY  - JOUR
AU  - Eusepi,Stefano
AU  - Preston,Bruce
TI  - Stabilizing Expectations under Monetary and Fiscal Policy Coordination
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 14391
PY  - 2008
Y2  - October 2008
UR  - http://www.nber.org/papers/w14391
L1  - http://www.nber.org/papers/w14391.pdf
N1  - Author contact info:
Stefano Eusepi
Macroeconomic and Monetary Studies Function
Federal Reserve Bank of New York
33 Libery street
New York, NY 10045-0001
E-Mail: stefano.eusepi@ny.frb.org

Bruce Preston
Department of Economics
Columbia University
420 West 118th Street
New York, NY 10027
Tel: 212/854-4092
Fax: 212/854-8059
E-Mail: bp2121@columbia.edu
AB  - This paper analyzes the constraints imposed on monetary and fiscal policy design by expectations formation. Households and firms learn about the policy regime using historical data. Regime uncertainty substantially narrows, relative to a rational expectations analysis of the model, the menu of policies consistent with expectations stabilization. There is greater need for policy coordination: the specific choice of monetary policy limits the set of fiscal policies consistent with macroeconomic stability --- and simple Taylor-type rules frequently lead to expectations-driven instability. In contrast, non-Ricardian fiscal policies combined with an interest rate peg promote stability. Resolving uncertainty about the prevailing monetary policy regime improves stabilization policy, enlarging the menu of policy options consistent with stability. However, there are limits to the benefits of communicating the monetary policy regime: the more heavily indebted the economy, the greater is the likelihood of expectations-driven instability. More generally, regardless of agents' knowledge of the policy regime, even when expectations are anchored in the long term, short-term dynamics display greater volatility than under rational expectations.
ER  -