This research proposal is finalized to study the macroeconomic implications of monetary and fiscal policy interactions in an monetary model environment where private sector¿s beliefs are subject to bounded rationality schemes. The novelty of our theoretical approach emerges from the joint consideration of i) potentially time/state-varying individuals¿ learning rules and ii) fiscal/monetary policy interacting regimes that may switch according to Markov processes. We apply this model setting to test its consistency with two stylized facts currently debated in the macro literature: i) the one addressing regime-switching fiscal policy effectiveness and non-linear trend-cycle relations; ii) the one addressing asset price volatility and the emergence of financial bubbles. In the fist place, we estimate Markov-Switching Structural Vector Auto-Regressions (MS-SVARs) with novel Bayesian methods to produce fresh empirical evidence supporting the idea of a state-dependent effectiveness of both fiscal and monetary policy. Such a regime-switching effectiveness is evaluated conditional on set-identified sources of macroeconomic variability. In the second place, by taking appropriate extensions of the monetary model, we then calibrate its structure to replicate the non-linear dynamics emerging from the MS-SVARs. Calibrations are obtained by a modified impulse response matching strategy which is able to take into account regime changes. Technically, this requires using using a non linear numerical solution routine for rational expectations models jointly considering the calibration of both the parameters space and of the transition probability matrix for the Markov-switching model. The recent research showing substantial macroeconomic non-linearity and structural breaks in time series data provide an encouraging starting point for the results expected from this project
Theoretical Model.
The model departs from the literature on learning and deviations from the REH in two main directions. First, it introduces agents with limited information in an economy where also rational agents live. The emergence of these two behaviors considering the boom/bursts cycle-generating waves of over/under confidence. Secondly, this way of modeling agents' preferences is nested inside a monetary model where policy interactions jointly determine price and debt levels, according to MS dynamics. The combination of policy interactions in MS environments and learning behaviors comes as a novelty in the literature as it opens the debate in two directions: i) when assessing uncertainty in policy interactions, by embedding heterogeneity in agents' attitudes toward uncertainty allows assessing the effect of adaptive learning on policy-making; ii) by introducing policy regimes in an heterogeneous information context allows researchers to gauge the distributional consequences of policy interactions.
Application 1.
Despite the trend-cycle relation has already been introduced in the literature, implications for the optimal size and composition of public expenditure have not yet been investigated. We can get new insights by studying the growth-maximizing fiscal policy design in an environment where a fraction of agents does not behave according to the REH. Once short-run effectiveness of fiscal policy and dependence of long-run growth on the short-run fluctuations are established, the composition of public expenditure may affect macro-dynamics in two ways. First, if private R&D investment are crowded-in by short-run expansionary effect of public investment, the growth-maximizing share public investment could exceed the output elasticity of public expenditure. Second, if alternative types of public expenditure have different short-run multipliers, the optimal composition of public expenditure may change, and require a positive share of public consumption.
Application 2:
The role of monetary policy for the prevention and stabilization of financial bubbles has not yet been studied conditional to abrupt regime-shifts and set-identified shocks. In this perspective, our research objectives constitute an original contribution to the empirical literature. Even more innovative results could come by extending the theoretical model displaying bounded rationality and regime-changes to the rational bubbles theory, underlying the regimes in which the monetary policy trade-off for financial market stabilization actually emerges.
Essential References/State of the art:
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