Lack of Fiscal expectations could undermine Taylor rule

I had said earlier we should read Eric Leeper. He brings really interesting interactions between fiscal and monetary policy. His research centres on the idea that managing and anchoring fiscal expectations is as crucial. We usually worry about inflation and central bank expectations and never really look at fiscal policies. This is not surprising as much of research has focused on monetary policy. The mon pol research has looked at DSGE models (see this as well) which do not have any role of fiscal policy.

Nevertheless, times are changing and we are seeing some research on fiscal policy. Much of the fight is between fiscal multipliers.  It is high time we start to engage in research like we do for central banks- rules, institutions, frameworks etc.

Econs like Leeper are helping us think through these ideas.

In a new paper Leeper says:

Slow moving demographics are aging populations around the world and  pushing many countries into an extended period of heightened fiscal stress. In some countries, taxes alone cannot or likely will not fully fund projected pension and health care expenditures. If economic agents place sufficient probability on the economy hitting its ”fiscal limit” at some point in the future–after which further tax revenues are not forthcoming–it may no longer be possible for “good” monetary policy—behavior that obeys the Taylor principle—to control inflation or anchor inflation expectations. In the period leading up to the fiscal limit, the more aggressively that monetary policy leans against inflationary winds, the more expected inflation becomes unhinged from the inflation target. Problems confronting monetary policy are exacerbated when policy institutions leave fiscal objectives and targets unspecified and, therefore, fiscal expectations unanchored. In light of this theory, the paper contrasts monetary fiscal policy frameworks in the United States and Chile.

The paper is fairly technical and needs a patient reading. It would have been better if he explained the broad ideas in English and put the technical details in appendix. For instance he gives you scenarios of active fiscal policy vs monetary policy and vice versa. One does not get a proper idea on what the analysis actually show.

But one gets a broad idea on what the paper implies. Anchoring fiscal expectations is important as it undermines monetary policy as well. The idea that at some point of time taxes will not be able to fund the growing expenditures and pension liabilities is a threat. So, we need some clarity on how governments plan to manage their public finances. With no clarity, monetary policy would also suffer. There have been many instances in the past when  fiscal policy mess has resulted in a monetary policy mess as well.

The case studies of US and Chile are contrasting and interesting stuff.

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