The Implication of Monetary and Fiscal Policy Interactions for the Price Levels: the Fiscal Theory of the Price Level Revisited

Abstract

This paper aims to contribute to the empirical literature on the interaction between monetary and fiscal policy. We consider the impact of monetary and fiscal policy shocks on inflation and output dynamics using a Time-Varying Parameter Factor-Augmented VAR (TVP-FAVAR). In baseline results from a linear model, including fiscal policy in the factors has implications for the impact of monetary policy shocks on inflation. This can be explained with the generated positive wealth effects. Moreover, results from our TVPFAVAR indicate that price puzzles from monetary policy shocks are more accentuated during particular regimes. For example, under coordination of Fiscal-Active with Monetary-Passive policy during the Burns and Volcker regime of 1970s and 1980s inflation rise in response to a contractionary monetary policy shock. Likewise the baseline model, the underlying mechanism can be explained through the wealth effect channel. Finally, the results of a fiscal expansionary policy provide support for the non-Ricardian view on fiscal policy within both the linear and non-linear FAVAR model.