Optimal fiscal policy propagation of monetary policy shocks

by Kanda, Daniel Stanley

This thesis consists of three essays which examine the response of fiscal policy to monetary poiïcy shocks, and the implications of this reçponse for other macre economic variables of interest. The hst essay e~amhes the optimal dynamic response of government expendi- tue, public debt, and taxes to an unanticipated monetary policy decision made by an independent centrai bank. 1 develop an dension of the LucasFuerst liquidity effects mode1 which indudes an endogenous government agent. and in which the iiquidity effect initidy dominates the anticipated idation effec t. In the period of a positive rnonetary shock, the optimal response is to increase public debt and govern- ment expenditure, to take advantage of lower interest rates. In subsequent periods. as anticipated dation effects becorne dominant. debt and expenditure fd as the interest rate rises. Taxes fall as the anticipated inflation efkt becomes dominant, in order to minimise the negative impact of higher prices on household consump tion. This outhes an additional propagation mechanism. where monetary shocks affect fiscal policy, which then affects output and employment. 1 also show that Christiano and Eichenbaum's (1992a) dominant liquidity effect is not robust to the introduction of a utility maximising government agent into the credit market. Recent research has shown that models which incorporate monopolistic competi- tion. sticky prices. and pricing-to-market are able to generate predictions about the international monetazy transmission mechanism which are consistent with empirical evidence. In the second essay, 1 introduce a govemment sector hto an open economy mode1 with these features. and examine the optimal response of fiscal policy to monetary policy shocks. shocks to world inflation, and shocks to world real interest rates. I find that assuming ked tax rates for govemment increases the scale and persistence of the liquidity effkct. The thVd essay uses the vector autoregression methods pioneered by Sims (1980) to examine the dynamic responses of govemment expenditure, real total revenue, real tax revenue, and red outstanding public debt, to monetary policy shocks. This is done for both United States and Canadian data. 1examine the magnitude and direction of the responses, as wd as their statistical significance.