This paper studies optimal simple interest rate rules in economies with recurring active fiscal policy regimes. We describe the optimal monetary policy responses over a large parameter space using a generalization of the Leeper (1991) determinacy conditions. A substantial region of the parameter space features time-invariant interest rate rules, notably interest rate pegs. This is true even for models of adaptive learning in which regime changes may be unobserved. Hence, there are cases for which it is neither optimal nor necessary for central banks to track changes in the fiscal policy stance. Still, a large region of the fiscal policy parameter space requires central banks to respond to the underlying fiscal regime.
This paper addresses the relationship between determinacy and E-stability in a general class of Markov-switching DSGE (MS-DSGE) models with lagged endogenous variables. We prove that determinacy conditions from Cho (2016) and Cho (2019) imply the E-stability of the unique solution when agents condition their expectations on contemporaneous variables and use one-step-ahead decision rules. We therefore extend the main result of McCallum (2007) to a class of DSGE models with time-varying parameters. As with linear DSGE models, E-stability conditions are weaker than determinacy conditions, but we show that MS-DSGE models present new cases where indeterminate models feature E-stable MSV solutions. In particular, we employ a New Keynesian model with recurring exogenous interest rate regimes and show that indeterminacy can obtain when our E-stability condition, which coincides with the Long Run Taylor Principle, is satisfied.
New Keynesian models predict implausible responses to anticipated structural changes, a phenomenon known as the forward guidance puzzle. We use tractable necessary and sufficient conditions for when a model exhibits a forward guidance puzzle to characterize restrictions on fiscal policy that eliminate forward guidance puzzles. We show that permanent or recurring active fiscal policy regimes can severely dampen equilibrium responses to forward guidance. Moreover, uncertainty about future fiscal policy by itself may severely dampen equilibrium responses to forward guidance.
Maturity, Determinacy and Policy Regimes (under revision)
This paper explores some determinacy properties of a New Keynesian model with recurring fiscal and monetary policy regimes. We find that the maturity structure of government debt matters for determinacy and the existence of stable equilibria in the switching model, which is not true in standard monetary models with fixed policy regimes. In particular, central banks can typically embrace more overall active monetary policy stances in models with recurring active fiscal policy regimes when the maturity structure of debt held by households is longer. We argue that this gives central banks an incentive to twist the maturity structure of debt in order to choose interest rate rules that more effectively stabilize inflation.
Work in Progress
Does my model predict a forward guidance puzzle? (with Christopher G. Gibbs)
Heterogenous Learning and the Value of Intergenerational Knowledge Transfers (with Tristan Nighswander)
Expectational Stability and Interest Rate Pegs (coming soon)
Adaptive Learning in Hidden Markov Models