Regime Switching Monetary and Fiscal Policies

This note presents a stylized model of monetary and fiscal policies in which policy regime evolves randomly according to a Markov chain. This simple model is designed to illustrate that well-defined and unique equilibria can exist even in such an environment. It also shows that under certain assumptions about policy behavior, tax disturbances can generate wealth effects in line with the fiscal theory of the price level even if the current regime is one when monetary policy is active and fiscal policy is passive. This suggests that the fiscal theory mechanism may operate more generally than fixed-regime models seem to imply. Canzoneri, Cumby, and Diba (2001) (CCD) argue that Ricardian equilibria are, in a certain sense, more general than non-Ricardian equilibria. They make this argument by proving a proposition that states that over time the response of the government surplus to total government liabilities merely needs to be bounded away from zero infinitely often for the equilibrium to exhibit Ricardian Equivalence. The key point is that the private sector must expect taxes to adjust “sooner or later,” though the adjustment can be arbitrarily small and infrequent. Because the proposition does not require the fiscal response to be strong enough to make the evolution of government debt stable, the Ricardian equilibria CCD consider are potentially ones with an unbounded debt-output ratio. Equilibria with unbounded debt-output ratios may not be the most interesting or relevant ones to consider. And they may be misleading if the impacts of taxes hinge on the unboundedness assumption. Unbounded debt-output ratios are well outside any country’s experience, so it is impossible to tell if policy authorities would permit such equilibria to occur. It is quite possible that if a country’s policies made its debtoutput ratio appear to grow without limit, the country would undergo fundamental macro policy reforms of the type that neither we nor CCD consider. We assume the political process ensures the debt-output ratio is bounded.