FRBSF Economic Letter
2005-12; June 10, 2005
Fiscal
and Monetary Policy: Conference Summary
This Economic Letter summarizes
the papers presented at a conference on "Fiscal and
Monetary Policy" held at the Federal Reserve Bank
of San Francisco on March 4 and 5, 2005. The papers are
listed at the end and are available on our website.
This
year's conference brought together six research papers
that explore issues related to fiscal and monetary policy
and their interaction. The papers ranged from a theoretical
analysis of the design of fiscal policy in a monetary
union to the use of long-term bond rates to estimate monetary
policy reaction functions.
Several of the papers examine
the role of fiscal policy in macroeconomic stabilization,
an area of renewed interest
in both research and policy circles. Over the past
few decades, many economists had come to the conclusion
that
activist fiscal policy, outside of so-called "automatic
stabilizers," such as unemployment insurance,
was in general poorly suited as a tool for macroeconomic
stabilization. According to this view, fiscal policy
should instead primarily
focus on longer-run issues, including the provision
of
public goods, correction of market failures, and the
achievement of equity and efficiency goals.
Recent
developments, including the active use of countercyclical
fiscal policy in Japan and the United States and the
formation of a monetary union in Europe, have provided
an impetus
for a wide range of research on fiscal policy and its
interaction with monetary policy, as represented by
four of the conference
papers. Iwamura, Kudo, and Watanabe study the use of
monetary and fiscal policy in Japan during its prolonged
downturn.
Galí and Monacelli argue that national fiscal
policy in a monetary union should take over some of
the short-run
stabilization duties normally performed by monetary
policy. Benhabib and Eusepi look at the interaction
between fiscal
and monetary policy and show that the design of monetary
policy should be sensitive to how fiscal policy is
conducted. And Perotti examines the empirical evidence
regarding the
effects of changes in government spending and taxes
on the economy.
The remaining two papers focus on issues
related to monetary policy. Brock, Durlauf, and West
analyze the
design of
monetary policy rules in an environment where the
policymaker is uncertain about the true structure of the
economy.
Ang, Dong, and Piazzesi develop a new method of estimating
monetary
policy reaction functions using information in the
entire interest rate term structure.
Fiscal and monetary policy
in Japan
For many years now, Japan has been suffering from slow
or at times contracting economic activity and deflation.
In response, policymakers in Japan have taken a number
of steps to stimulate the economy through monetary and
fiscal policies. Notably, in February 1999 the Bank of
Japan lowered the overnight nominal interest rate to zero,
as low as it can go. After a small policy tightening, in
March 2001 the overnight cash rate was again lowered to
zero and it has remained at zero since then. To understand
why the Japanese economy has been slow to recover, Iwamura,
Kudo, and Watanabe develop a model of the economy and use
it to study the interaction between fiscal and monetary
policy and the characteristics of optimal monetary policies.
They find that the policy pursued by the Bank of Japan
between 1999 and 2004 lacked important characteristics
of optimal monetary policy, and, in particular, they suggest
that the Bank of Japan may not have been fully committed
to its zero-interest rate policy. They also show that the
term structure of interest rates was not downward sloping
after 1998, indicating that the Bank of Japan's policy
failed to have sufficient influence on market expectations
about the future course of monetary policy. Finally, the
authors argue that Japan should have run larger government
deficits and that the combination of this fiscal policy
and the Bank of Japan's apparent lack of commitment to
low interest rates has delayed economic recovery in Japan.
Optimal fiscal policy in
a monetary union
The creation of a monetary union in Europe, which is set
to expand to include several more countries in coming years,
offers new challenges for fiscal and monetary policymakers.
Part and parcel of joining a monetary union is the loss
of independent monetary policies in each of the member
countries, which limits the ability to use monetary policy
to stabilize economic disturbances that affect only a subset
of the countries in the union. Nonetheless, member countries
are still at liberty to formulate independent fiscal policies,
and Galí and Monacelli tackle the question of how
to design jointly optimal national fiscal policies and
the collective monetary policy to maximize the welfare
of the entire union. A key finding is that when prices
are sticky, members of a monetary union will have a motive
for fiscal stabilization that extends beyond the simple
optimal provision of public goods. This motive for fiscal
stabilization emerges because monetary policy, which would
normally be used to stabilize the economy in response to
country-specific shocks, can instead be used only to address
union-wide disturbances. To stabilize a member economy,
national fiscal policy should "lean against the wind," with
policy expansionary when output and inflation are below
their equilibrium levels and contractionary when they are
above their equilibrium levels.
The interaction of monetary
and fiscal policy
Monetary policy rules are often expressed such that the
choice variable for the central bank, usually a short-term
nominal interest rate, is determined by a number of economic
variables according to a mathematical equation. However,
a well-known problem with such rules is that certain specifications
of the rule can lead to indeterminacy, that is, an economy
for which many different outcomes are possible given the
same fundamental economic situation. Clearly, a good monetary
policy should avoid such non-uniqueness. One widely discussed
solution that works in many models is to have the interest
rate rule be "active," in the sense that the
nominal interest rate responds more than one-for-one to
movements in the inflation rate. But, this solution may
not be sufficient to avoid indeterminacy in all models.
Benhabib and Eusepi examine the interaction of monetary
and fiscal policy and the conditions for indeterminacy.
They show that when households are able to save by buying
bonds, then the conduct of fiscal policy and the resulting
interaction between fiscal and monetary policy can be critical
to whether indeterminacy occurs. Interestingly, they also
show that active monetary policy rules that also respond
to an output gap, as in the well-known Taylor rule, facilitate
the avoidance of indeterminacy.
The effects of fiscal policy
While many economists agree that expansionary monetary
policy eventually manifests itself in higher output and
prices, they generally do not agree about the effects of
expansionary fiscal policy. Some theories suggest that
a fiscal expansion will cause private consumption to decline
through "crowding out," while others predict
that private consumption will rise. Weighing in on this
issue, Perotti studies the effects of government spending
shocks and tax shocks in Australia, Canada, West Germany,
the United Kingdom, and the United States, employing the
same statistical methods that are commonly used to identify
and quantify the effects of monetary policy shocks to separate
innovations to government spending and taxes from the systematic
responses of these variables to the state of the economy.
Some key results from this study are that the effects of
fiscal policy shocks on GDP tend to be small overall but
that the effects of shocks prior to 1980 tend to be much
larger than those after 1980. He also finds no evidence
that tax cut shocks work any faster or have larger effects
than government spending shocks and that, for the post-1980
period, positive shocks to government spending and negative
shocks to taxes tend to elicit negative responses in GDP,
private consumption, and private investment.
Model uncertainty and policy evaluation
Monetary policymakers
recognize that they face a great deal of uncertainty
about the outlook for the economy
and the effects of policy on that outlook. Brock, Durlauf,
and West develop a general framework for how policymakers
should formulate, assess, and evaluate different policy
options in an uncertain world. Their approach incorporates
model uncertainty into standard statistical calculations,
thereby integrating model uncertainty into policy evaluation.
They illustrate their methods using two classes of
macroeconomic models that differ in the treatment of expectations.
In the "backward" class of models, expected
inflation is treated as a distributed lag over past inflation;
in their "hybrid" class, expected inflation
is partly forward-looking and partly backward-looking.
When model uncertainty is present, they show that a Taylor
rule, in which the nominal interest rate responds to
current inflation and the current output gap, is very
robust in the sense that risk estimates show relatively
little variation across models. However, they also show
that a three-parameter rule that responds to the lagged
interest rate in addition to current inflation and the
contemporaneous output gap, where the parameters in the
rule are optimized for model uncertainty, generally does
better than the Taylor rule in the backward-looking model
and uniformly does better than the Taylor rule in the
hybrid model. No-arbitrage Taylor rules
According to standard asset pricing
theory, long-term interest rates should reflect risk-adjusted
future
short-term interest
rates, and, as a result, the entire term structure
can in principle be very informative about market participants'
views of the conduct of monetary policy today and in
the future. Ang, Dong, and Piazzesi exploit the relationship
between long-term bond rates and expected short-term
interest
rates to estimate monetary policy reaction functions
rules for the United States. They embed various specifications
of Taylor monetary policy rules in a model of the Treasury
security term structure that assumes that investors
have
fully exploited all arbitrage opportunities. They allow
for time-varying bond risk premiums that may depend
of the state of the economy. In principle, employing information
from the entire term structure for estimation can produce
more efficient estimates of how monetary policy shocks
affect the economy. The authors find that over 60%
of
the
time variation in yields can be attributed to shocks
to either GDP growth or inflation and that movements
in yield
spreads are largely due to shocks to inflation. Furthermore,
they find that monetary policy shocks estimated under
the no-arbitrage assumption are much less volatile
than those
found by standard methods. Richard Dennis
Economist
John Williams
Senior Vice President and Advisor
Conference Papers
Iwamura, Mitsuru, Takeshi Kudo, and
Tsutomu Watanabe. "Monetary
and Fiscal Policy in a Liquidity Trap: The Japanese Experience
1999-2004." National
Bureau of Economic Research Working Paper #11151.
Galí,
Jordi, and Tommaso Monacelli. "Optimal
Fiscal Policy in a Monetary Union." Mimeo.
Benhabib,
Jess, and Stefano Eusepi. "The
Design of Monetary and Fiscal Policy: A Global Perspective." Mimeo.
Perotti,
Roberto. "Estimating
the Effects of Fiscal Policy in OECD Countries." European Central Bank
Working Paper #168.
Brock, William, Steven Durlauf,
and Kenneth West. "Model
Uncertainty and Policy Evaluation: Some Theory and
Empirics." Social
Systems Research Institute Working Paper #2004-19.
Ang,
Andrew, Sen Dong, and Monika Piazzesi. "No-Arbitrage
Taylor Rules." Mimeo.
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do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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