Abstract
This paper analyzes global dynamics in a macroeconomic model where both monetary and fiscal policies are nonlinear, consistent with empirical evidence. Nonlinear monetary policy, in which the nominal interest rate features an increasing marginal reaction to inflation, interacting with nonlinear fiscal policy, in which the primary budget surplus features an increasing marginal reaction to debt, gives rise to four steady-state equilibria. Each steady state exhibits in its neighborhood a pair of ‘active’/‘passive’ monetary/fiscal policies à la Leeper-Woodford, and is typically investigated in isolation within linearized monetary models. We show that, when global nonlinear dynamics are taken into account, such steady states are endogenously connected. In particular, the global dynamics reveals the existence of infinite self-fulfilling paths that originate around the steady states locally displaying either monetary or fiscal ‘dominance’—and thus locally delivering equilibrium determinacy—as well as around the unstable steady state with active monetary-fiscal policies, and that converge into an unintended high-debt/low-inflation (possibly deflation) attractor. Such global trajectories—bounded by two heteroclinic orbits connecting the three out-of-the-trap steady states—are, however, obscured if the four monetary-fiscal policy mixes are studied locally and disjointly.
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Notes
As the discussion of the related literature in the following section shall point out, the body of studies empirically supporting the scope for nonlinear feedback interest rate policy rules is large. It includes, for instance, Dolado et al. (2000, 2004, 2005), Martin and Milas (2004), Taylor and Davradakis (2006), Petersen (2007), Cukierman and Muscatelli (2008), Hayat and Mishra (2010), Castro (2011), Klose (2011), Miles and Schreyer (2012, 2014), Naraidoo and Paya (2014), Lee and Son (2013), Kulikauskas (2014), Neuenkirch and Tillmann (2014), Sznajderska (2014), Ma (2016), and Shen et al. (2016).
The empirical research detecting nonlinear fiscal adjustments is also extensive. It includes, for example, Bohn (1998), Sarno (2001), Arestis et al. (2004), Bajo-Rubio et al. (2004, 2006), Arghyrou and Luintel (2007), Chortareas et al. (2008), Considine and Gallagher (2008), Cipollini et al. (2009), Legrenzi and Milas (2012a, b, 2013), Arghyrou and Fan (2013), and Piergallini and Postigliola (2013).
Piergallini (2016) shows that a fiscal policy displaying convex nonlinearity in the surplus-debt relationship is an independent source of multiplicity of steady-state equilibria. To establish this result, he assumes a conventional linear Taylor rule. By contrast, in this paper we attempt to analyze the dynamic effects of a nonlinear behavior in fiscal policy conduct interacting with a nonlinear behavior in monetary policy conduct.
Fiscal policy is ‘passive’ (‘active’) in Leeper’s (1991) sense when the primary budget surplus set by the government brings about local stability (instability) of government liabilities for all stable paths of the other endogenous variables—such as inflation and output—in the neighborhood of a steady state. Monetary policy is ‘active’ (‘passive’) in Leeper’s (1991) sense when the nominal interest rate set by the central bank increases by more (less) than one-for-one with respect to an increase in the inflation rate, thereby verifying (violating) the Taylor (1993) principle (Woodford 2003). See Canzoneri et al. (2011), and Leeper and Leith (2016) for comprehensive analyzes and literature reviews on the interactions between monetary and fiscal policies.
This assumption is meant to guarantee that, at the steady states, real money demand is bounded, as in Benhabib et al. (2001).
For simplicity and without loss of generality, we set public consumption equal to zero.
This assumption is meant to ensure that, at the steady states, government liabilities are strictly positive.
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Acknowledgements
I am very grateful to three anonymous referees for many valuable comments and suggestions. I also wish to thank Giorgio Rodano for very helpful discussions on this line of enquiry and Paolo Canofari, Alessia Franzini, Alessandro Leopardi and Michele Postigliola for very useful comments and remarks. The usual disclaimers apply.
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Piergallini, A. Nonlinear policy behavior, multiple equilibria and debt-deflation attractors. J Evol Econ 29, 563–580 (2019). https://doi.org/10.1007/s00191-018-0562-8
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DOI: https://doi.org/10.1007/s00191-018-0562-8
Keywords
- Nonlinear monetary and fiscal policy behavior
- Evolutionary macroeconomic modeling
- Multiple equilibria
- Global nonlinear dynamics
- Debt-deflation traps