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

Using a micro-founded model and a likelihood based inference method, we address three questions in this paper. First, what monetary and scal policy regimes characterized post-war U.S. data? Second, was equilibrium indeterminacy a feature of the economy before Paul Volcker's chairmanship at the Federal Reserve? Third, what were the effects of shifts in monetary and scal policy on the aggregate economy? We nd that pre-Volcker, a passive monetary and scal policy regime prevailed while postVolcker, an active monetary and passive scal policy regime characterized the economy.1 Since both monetary and scal policies were passive pre-Volcker, there was equilibrium indeterminacy. Moreover, the effects of monetary and scal policy shifts on the aggregate economy were substantially different in the two time periods. For example, while pre-Volcker, an unanticipated increase in interest rates led to an increase in output and in ation but a decline in government debt-to-output ratio, post-Volcker, it led to a decline in output and in ation but an increase in debt-to-output ratio. Moreover, while pre-Volcker, an unanticipated increase in the tax revenues-to-output ratio led to a decline in output, in ation, and debt-to-output ratio, postVolcker, it led to a decline in debt-to-output ratio but had no effects on output or in ation. The response of the economy pre-Volcker was thus similar to that predicted by the scal theory of the price level (FTPL). Following an in-