Federal Reserve Bank of Dallas

Using an estimated DSGE model that features monetary and fiscal policy interactions and allows for equilibrium indeterminacy, we find that a passive monetary and passive fiscal policy regime prevailed in the pre-Volcker period while an active monetary and passive fiscal policy regime prevailed post-Volcker. Since both monetary and fiscal policies were passive pre-Volcker, there was equilibrium indeterminacy which resulted in substantially different transmission mechanisms of policy as compared to conventional models: unanticipated increases in interest rates increased inflation and output while unanticipated increases in lump-sum taxes decreased inflation and output. Unanticipated shifts in monetary and fiscal policies however, played no substantial role in explaining the variation of inflation and output at any horizon in either of the time periods. Pre-Volcker, in sharp contrast to postVolcker, we find that a time-varying inflation target does not explain low-frequency movements in inflation. A combination of shocks account for the dynamics of output, inflation, and government debt, with the relative importance of a particular shock quite different in the two time-periods due to changes in the systematic responses of policy. Finally, in a counterfactual exercise, we show that had the monetary policy regime of the post-Volcker era been in place pre-Volcker, inflation volatility would have been lower by 34% and the rise of inflation in the 1970s would not have occurred. JEL codes: C52, C54, E31, E32, E52, E63 * Saroj Bhattarai, Pennsylvania State University, Department of Economics, 615 Kern Building, University Park, PA 16802. 814-863-3794. [email protected]. Jae Won Lee, Department of Economics, Rutgers University, 75 Hamilton Street, NJ Hall, New Brunswick, NJ 08901. [email protected]. Woong Yong Park, School of Economics and Finance, Room 1007, 10/F, K.K. Leung Building, The University of Hong Kong, Pokfulam Road, Hong Kong. [email protected]. We are grateful to Eric Leeper, Chris Sims, seminar participants at the Federal Reserve Bank of Kansas City and Bank of Korea, and conference participants at the Annual American Economic Association Meetings for comments and criticisms. This version: Jan 2012.The views in this paper are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.