Interactions between Fiscal and Monetary Policy: A New Keynesian Model with Regime Switching Process
This paper examines the interactions between traditional fiscal and monetary policy tools: government spending and the interest rate. Two models are used: a baseline linear model, and a Markov switching model with active/passive fiscal and monetary policy combinations. The linear model is estimated and the posterior mean parameterization is used to calibrate the regime-switching model. Sims (2002) algorithm and policy function iteration are used to solve the models, and a particle filter is used to evaluate the likelihood functions. The results show that government spending alone cannot raise inflation despite the positive effect on output. The duration of the stimulus effect in output increases significantly under active fiscal regime. The strongest effect occurs when both monetary and fiscal policy are active.
