Monetary-Fiscal Mix and Inflation Performance: Evidence from the US

There has been a lot of interest recently in developing small scale
rule-based empirical macro models for the analysis of monetary policy.
These models, based on the conventional view that inflation
stabilization should be a concern of monetary policy only, have typically neglected
the role of fiscal policy. We start with the evidence that a baseline
VAR-augmented Taylor rule can deliver recurrent mispredictions of
inflation in the U.S. before 1987. We then show that a fiscal feed-back rule, in
which the primary deficit reacts to both the output gap and the
government debt, can well characterize the behavior of fiscal policy throughout the
sample. However, by employing Markov-switching methods, we find
evidence of substantial instability across fiscal regimes. Yet this precisely happens
\QTR{it}{before 1987}. We then augment the monetary VAR\ with a
fiscal policy rule and control for the endogenous regime switches for both
rules. We find that only over time windows belonging to the pre-1987 period
the model based on the two rules can predict the behavior of \ inflation
better than the one based just on the monetary policy rule. \QTR{it}{After
1987}, when fiscal policy is estimated to switch to a regime of fiscal discipline,
the monetary-fiscal mix can be appropriately described as a regime of
monetary dominance. Over this period a monetary policy rule based
model is always a better predictor of the inflation behavior than the one
comprising both a monetary and a fiscal rule.