Abstract. A growing body of evidence finds that policy reaction functions vary substantially over different periods in the United States. This paper explores how moving to an environment in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of policy shocks. In one regime monetary policy follows the Taylor principle and taxes rise strongly with debt; in another regime the Taylor principle fails to hold and taxes are exogenous. An example shows that a unique bounded non-Ricardian equilibrium exists in this environment. A computational model illustrates that because agents ’ decision rules embed the probability that policies will change in the future, monetary and tax shocks always produce wealth effects. When it is possible that fiscal policy will be unresponsive to debt at times, active monetary policy (like a Taylor rule) in one regime is not sufficient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks. The paper also considers the implications of policy switching for two empirical issues. 1.

We employ Markov-switching regression methods to estimate fiscal policy feedback rules in the U.S. for the period 1960-2002. Our approach allows to capture policy regime changes endogenously. We reach three main conclusions. First, fiscal policy may be characterized, according to Leeper (1991) terminology, as active from the 1960s throughout the 1980s, switching gradually to passive in the early 1990s and switching back to active in early 2001. Second, regime-switching fiscal rules are capable of tracking the time-series behaviour of the U.S. primary deficit better than rules based on a constant parameter specification. Third, regime-switches in monetary and fiscal policy rules do not exhibit any degree of synchronization. Our results are at odds with the view that the post-war U.S. fiscal policy regime may be classified as passive at all times, and seem to pose a challenge for the specification of the correct monetary-fiscal mix within recent optimizing macroeconomic models considered suitable for policy analysis.

at Indiana University Bloomington. CAEPR can be found on the Internet at:

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. The paper studies how high leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of the rich, a large increase in leverage for the remainder, and an eventual financial and real crisis. The paper presents a theoretical model where these features arise endogenously as a result of a shift in bargaining powers over incomes. A financial crisis can reduce leverage if it is very large and not accompanied by a real contraction. But

Abstract We develop a closed economy model in order to study the interactions among sovereign risk premia, fiscal limits and fiscal policy. Default risk premia reflect the market's expectations about the ability and willingness of the government to service its debt. The government's ability arises endogenously from fiscal limits implied by Laffer curves, while the government's willingness is determined by the flexibility of its fiscal policy. The model rationalizes different sovereign ratings across developed countries. The distribution of fiscal limits is country specific and depends on the size of the government, the degree of the countercyclical policy responses, economic diversity and political uncertainty. The model also produces a nonlinear relationship between sovereign risk premia and the level of government debt. In recessions, the default risk premia of long-term bonds jump ahead of shortterm bonds and provide early warnings of sovereign defaults. The nonlinearity is consistent with the empirical evidence that once risk premia begin to rise, they do so rapidly. In addition, the model predicts substantial risk premia that are close to those observed, even when the probability of defaulting is remote. Risk premia carry substantial economic costs, lowering consumption and output for extended periods. * I am deeply grateful to my advisor, Eric Leeper, for his constant encouragement and thoughtful advice. I am indebted to Troy Davig for his advice and support throughout this project. I also thank Brian Peterson, David Romer, Juergen von Hagen and Todd Walker for many useful suggestions. I thank all the seminar participants at

Abstract The paper explores the macroeconomic consequences of fiscal consolidations whose timing and composition are uncertain. Drawing on the evidence in Alesina and Ardagna (2010), we emphasize whether or not the fiscal consolidation is driven by tax rises or expenditure cuts. We find that the composition of the fiscal consolidation, its duration, the monetary policy stance, the level of government debt and expectations over the likelihood and composition of fiscal consolidations all matter in determining the extent to which a given consolidation is expansionary and/or successful in stabilizing government debt.

Abstract not found

Slow moving demographics are aging populations around the world and pushing many countries into an extended period of heightened fiscal stress. In some countries, taxes alone cannot or likely will not fully fund projected pension and health care ex-penditures. If economic agents place sufficient probability on the economy hitting its “fiscal limit ” at some point in the future—after which further tax revenues are not forthcoming—it may no longer be possible for “good ” monetary policy behavior to control inflation or anchor inflation expectations. In the period leading up to the fiscal limit, the more aggressively that monetary policy leans against inflationary winds, the more expected inflation becomes unhinged from the inflation target. Problems con-fronting monetary policy are exacerbated when policy institutions leave fiscal objectives and targets unspecified and, therefore, fiscal expectations unanchored.

This paper uses Bayesian methods to estimate the ‘fiscal limit ’ distribution for Greece implied by a rational expectations framework. We build a real business cycle model that allows for interactions among fiscal policy instruments, the stochastic ‘fiscal limit,’ and sovereign default. A fiscal limit measures the debt level beyond which the government is no longer willing to finance, causing a partial default to occur. The fiscal policy specification takes into account government spending, lump-sum transfers, and distortionary taxation. Using the particle filter to perform likelihood-based inference, we estimate the full nonlinear model with post-EMU data until 2010Q4. We find that the probability of default on Greek debt remained close to zero from 2001 until 2009, and then rose sharply to the range of 5 % to 10 % by 2010Q4. The model also predicts a probability of default between 60-80 % by 2011Q4, consistent with the debt restructuring arrangements that took place at the beginning of 2012. In addition, the surge in the real interest rate in Greece in 2011 is within forecast bands of our rational expectations model. Finally, model comparisons based on Bayes factors strongly favor

Solving dynamic models with inequality constraints poses a challenging problem for two ma-jor reasons: dynamic programming techniques are reliable but often slow, while Euler equation based methods are faster but have problematic or unknown convergence properties. This pa-per attempts to bridge this gap. I show that a common iterative procedure on the first-order conditions – usually referred to as time iteration – delivers a sequence of approximate policy functions that converges to the true solution under a wide range of circumstances. These cir-cumstances extend to a large set of endogenous and exogenous state variables as well as a very broad spectrum of occasionally binding constraints. 1.