Monetary-Fiscal Policy Interactions and Indeterminacy in Post-War U.S. Data

Using a micro-founded model and a likeli-hood based inference method, we address three questions in this paper. First, what monetary and fiscal policy regimes characterized post-war U.S. data? Second, was equilibrium indeter-minacy a feature of the economy before Paul Volcker’s chairmanship at the Federal Reserve? Third, what were the effects of shifts in mone-tary and fiscal policy on the aggregate economy? We find that pre-Volcker, a passive monetary and fiscal policy regime prevailed while post-Volcker, an active monetary and passive fis-cal policy regime characterized the economy.1 Since both monetary and fiscal policies were passive pre-Volcker, there was equilibrium inde-terminacy. Moreover, the effects of monetary and fiscal policy shifts on the aggregate economy were substantially different in the two time periods. For example, while pre-Volcker, an unantici-pated increase in interest rates led to an increase in output and inflation, post-Volcker, it led to a decline in output and inflation. Moreover, while pre-Volcker, an unanticipated increase in the (lump-sum) tax revenues-to-output ratio led to a decline in output and inflation, post-Volcker, it had no effects on output or inflation. The response of the economy pre-Volcker was thus similar to that predicted by the fiscal the-ory of the price level (FTPL).2 Under FTPL, a