RICERCA ITALIANA     

Monetary and Fiscal Stabilization policies, the exchange rate and the term structure of interest rates

Università Commerciale "Luigi Bocconi" - Milano

Abstract

The research program has two main objectives:
1) The analysis of the fiscal-monetary policy mix in the determination of macroeconomic outcomes
2) The analysis of the responses of asset prices, such as exchange rates and the term structure of interest rates to different identified shocks and systematic policies.
Our contribution will be both theoretical and empirical.
On the theory side we plan to extend the new-keynesian macroeconomic modelling approach to consider the impact of heterogeneous expectations and monetary and fiscal policy interactions in determining solution determinacy and E-stability conditions for the Rational Expectations Equilibrium
On the empirical side we shall estimate a New Keynesian model and use the estimated structural paramenters to investigate the design of optimal monetary and fiscal stabilization policies. Special attention will be devoted to the specification of fiscal policy rules.
Baseline models, which considers closed economy and no term structure of inteest rates, shall be then extended to evaluate the impact of policies on the exchange rates and on the term structure, with special attention for the term premia. The analyis of the term structure of interest rates will then give us the opportunity to introduce models of indexation for long-term bonds.
The research units in Bologna (Basevi with Marzo, Onofri and Lubik) and in Rome (Senesi with Mattesini and Scaramozzino) will mainly work on the theoretical modelling, while the empirics will be mainly done by the two milanese units (the Bocconi unit, Favero, Monacelli, Sala, Soderstrom and Trigari, and the Bicocca unit, Natale, Colombo, Muscatelli, Stanca and Tirelli). <<<

Principal Investigator

Carlo Ambrogio FAVERO Università Commerciale "Luigi Bocconi" MILANO

Research Objectives

The research program has two main objectives:
1) The analysis of the fiscal-monetary policy mix in the determination of macroeconomic outcomes
2) The analysis of the responses of asset prices, such as exchange rates and the term structure of interest rates to different identified policies.
Our contribution will be both theoretical and empirical.In particular we propose to extend the vaste empirical literature on monetary policy rules to fiscal policy rules. We shall then include rules in a small macro model the evaluate the importance of the fiscal-monetary policy mix in the determination of macroeconomic outcomes. All models considered will be estimated (on data for the US and the Euro area) and simulated for policy evaluation. We shall also extend the baseline closed economy model with a single financial asset to consider explicitly the impact of the policy mix on the exchange rates and the term structure of interest rates. <<<

First Results

Development of models viable to estimation, construction of databases relevant to the empirical applications, first empirical resultsModel utilization for policy analysis, production of working papers, submission to international journals. <<<

Timescale

24 months

National and international background

Recently we have witnessed a vivid interest in macroeconomics for the analysis of policy regimes. Yet nearly the whole literature (both theoretical and empirical) has focused on monetary policy in complete isolation, and in particular from fiscal policy. The main justification for this bias lies in the theoretically well-rooted paradigm according to which inflation stabilization should be a concern of the monetary authority only. The more independent such authority, the more credible and therefore the more successful in achieving the primary goal of reducing and stabilizing inflation. This view is at the core of the so-called New Keynesian monetary policy literature, centered around the polar star of the Taylor principle. See the widely cited work of Woodford (2003) and Clarida, Gali and Gertler (1999).

This conventional view typically suffers of two shortcomings. First, it often overlooks that, as emphasized for instance by Leeper (1991), Woodford (1996, 2001), Benhabib, Schmitt-Grohe and Uribe (2002), an appropriately defined monetary policy rule requires also an appropriately defined fiscal policy rule. Existence and uniqueness of rational expectations equilibria, as well as macroeconomic outcomes, hinge crucially on the underlying specification of the monetary-fiscal mix. Second, it typically assumes stability in the underlying fiscal policy regime. The latter is usually represented as passive (in the sense of Leeper, 1991), namely either featuring a sufficiently strong response of the fiscal deficit (and/or taxes) to variations in nominal debt, or, even more sharply, assuming that the government budget is balanced at all times.
A natural inertial element in the recent monetary literature is represented by the bounded rationality assumption and by the presence of heterogeneous expectations, as discussed by Bullard and Mitra (2002), Evans and Honkapohja (2001), Honkapohja and Mitra (2003a,b,c). Within this context, stabilization policies are evaluated also with respect to the concept of E-stability, regarding the possibility that agents without rational expectations converge to the equilibrium, by using a learning algorithm based on Recursive Least Squares method for forecast updating.
The recent contributions above mentioned study E-stability conditions in monetary models of the business cycle. The existing result show that monetary policy rules based on inflation and output gap forecasts can lead to indeterminacy of the equilibrium. However, indeterminacy does not appear to be a serious problem if the Rational Expectations Equilibrium (REE) is the only stable equilibrium of the model under learning updating scheme. According to the results outlined by FTPL indeterminacy of the equilibrium disappears by defining a fiscal policy rule setting the fiscal surplus as a function of the stock of real debt.


While research has soared in the empirical analysis of monetary policy rules, it is only recently that a number of authors have shifted the attention to the specification of fiscal policy in terms of reaction functions. Taylor (1996, 2000a, 2000b) argues that a fiscal rule can be specified for the U.S. by simply relating the measure of the fiscal stance to the deviation of output from its equilibrium level. He finds evidence of a countercyclical pattern of systematic fiscal policy. "Taylor fiscal rules" do not explicitly allow for a reaction to the evolution of the government debt. Bohn (1998) argues that a century of U.S data reveals a positive correlation between the Government surplus to GDP ratio and the government debt to GDP ratio.

We propose to contribute to the literature along two dimensions: a richer specification of the fiscal policy rule and an analysis of the interaction between monetary and fiscal policy rules.

We shall also consider the simultaneous investigation of monetary and fiscal policies via a regime-switching approach to understand the reaction of the term structure of interest rates to economic policies. Here we intend to build on the recent literature (see Roush(2003), Ellingsen and Soderstrom(2004)) which aims at modelling the behaviour of the term structure by analysing the conditional responses to different shocks rather than unconditional responses.

Finally we shall consider an open economy model to quantify the effects of fiscal policy on exchange rates, in order to determine how optimal monetary policy should take into account changes in fiscal variables. <<<