US fiscal regimes and optimal monetary policy

Fiscal policy in the US has been documented to have been the leading authority in the ‘60s and the ‘70s (active fiscal policy), while committing to make the necessary fiscal adjustments following Volcker’s appointment (passive fiscal policy). Moreover, while passive, US fiscal policy has at times fluctuated between raising taxes and cutting expenditure keeping the former relatively stable (Clinton expenditure cuts). I analyze those facts through the lens of three-regime New-Keynesian model with a Blanchard-Yaari structure. Fiscal policy is allowed to switch not only between an active and a passive regime, but also between expenditure cuts and tax increases while being passive. Focusing on determinacy regions (`a la Leeper (1991)), I show that the model can capture the fall in US debt-to-GDP ratio of the 70s and its subsequent rise following Volcker’s appointment. Performing beliefs counterfactuals, I show that the debt-to-GDP ratio could have been substantially lower had the US fiscal authorities committed to using federal expenditure as the only policy instrument. Finally optimal monetary policy shows that the Fed should increase its reaction to inflation considerably whenever Federal expenditure becomes the fiscal policy instrument.