Nonlinear Policy Behavior, Multiple Equilibria and Debt-Deflation Attractors

Piergallini, Alessandro (2018): Nonlinear Policy Behavior, Multiple Equilibria and Debt-Deflation Attractors.

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Nonlinear Monetary and Fiscal Policy Behavior; Evolutionary Macroeconomic Modelling; Multiple Equilibria; Global Nonlinear Dynamics; Debt-Deflation Traps.
• Subjects: C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C61 - Optimization Techniques ; Programming Models ; Dynamic Analysis; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C62 - Existence and Stability Conditions of Equilibrium; D - Microeconomics > D9 - Intertemporal Choice > D91 - Intertemporal Household Choice ; Life Cycle Models and Saving; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E63 - Comparative or Joint Analysis of Fiscal and Monetary Policy ; Stabilization ; Treasury Policy

References

Agliari, A., Naimzada, A. and Pecora, N. (2017), “Nonlinear Monetary Policy Rules in a Pure Exchange Overlapping Generations Model”, Journal of Evolutionary Economics 27, 1181-1203.

Alesina, A. and Drazen, A. (1991), “Why Are Stabilizations Delayed?”, American Economic Review 81, 1170-1188.

Arestis, P., Cipollini, A. and Fattouh, B. (2004), “Threshold Effects in the U.S. Budget Deficit”, Economic Inquiry 42, 214-222.

Arghyrou, M. G. and Luintel, K. B. (2007), “Government Solvency: Revisiting Some EMU Countries”, Journal of Macroeconomics 29, 387-410.

Arghyrou, M. G. and Fan, J. (2013), “UK Fiscal Policy Sustainability, 1955-2006”, Manchester School 81, 961-991.

Bajo-Rubio, O., Diaz-Roldan, C. and Esteve, V. (2004), “Searching for Threshold Effects in the Evolution of Budget Deficits: An Application to the Spanish Case”, Economics Letters 82, 239-243.

Bajo-Rubio, O., Diaz-Roldan, C. and Esteve, V. (2006), “Is the Budget Deficit Sustainable when Fiscal Policy is Non-linear? The Case of Spain”, Journal of Macroeconomics 28, 596-608.

Benhabib, J., Schmitt-Groh´e, S. and Uribe, M. (2001), “The Perils of Taylor Rules”, Journal of Economic Theory 96, 40-69.

Benhabib, J., Schmitt-Groh´e, S. and Uribe, M. (2002), “Avoiding Liquidity Traps”, Journal of Political Economy 110, 535-563.

Bertola, G. and Drazen, A. (1993), “Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity”, American Economic Review 83, 11-26.

Bohn, H. (1998), “The Behavior of U.S. Public Debt and Deficits”, Quarterly Journal of Economics 113, 949-963.

Brock, W. A. (1974), “Money and Growth: The Case of Long-run Perfect Foresight”, International Economic Review 15, 750-777.

Canzoneri, M. B., Cumby, R. and Diba, B. (2011), “The Interaction Between Monetary and Fiscal Policy”, in Friedman, B. and Woodford, M. (Eds.), Handbook of Monetary Economics, Amsterdam and Boston: North-Holland/Elsevier, 935-999.

Castro, V. (2011), “Can Central Banks’ Monetary Policy be Described by a Linear (Augmented) Taylor Rule or by a Nonlinear Rule?”, Journal of Financial Stability 7, 228-246.

Chortareas, G., Kapetanios, G. and Uctum, M. (2008), “Nonlinear Alternatives to Unit Root Tests and Public Finances Sustainability: Some Evidence from Latin American and Caribbean Countries”, Oxford Bulletin of Economics and Statistics 70, 645-663.

Cipollini, A., Fattouh, B. and Mouratidis, K. (2009), “Fiscal Readjustments in The United States: A Nonlinear Time-Series Analysis”, Economic Inquiry 47, 34-54.

Clarida, R., Gali', M. and Gertler, K. (2009), “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory”, Quarterly Journal of Economics 115, 147180.

Considine, J. and Gallagher, L. A. (2008), “UK Debt Sustainability: Some Nonlinear Evidence and Theoretical Implications”, Manchester School 76, 320-335.

Cukierman, A. andMuscatelli, A. (2008), “Nonlinear Taylor Rules and Asymmetric Preferences in Central Banking: Evidence from the United Kingdom and the United States”, The B.E. Journal of Macroeconomics 8, 1-31.

Dolado, J., Maria-Dolores, R. and Naveira, M. (2000), “Asymmetries In Monetary Policy Rules: Evidence For Four Central Banks”, CEPR Discussion Papers 2441.

Dolado, J., Maria-Dolores, R. and Naveira, M. (2005), “Are Monetary-policy Reaction Functions Asymmetric?: The Role of Nonlinearity in the Phillips Curve”, European Economic Review 49, 485-503.

Dolado, J., Maria-Dolores, R. and Ruge-Murcia, F. J. (2004), “Nonlinear Monetary Policy Rules: Some New Evidence for the US”, Studies in Nonlinear Dynamics and Econometrics 8, 1-32.

Dosi, G. and Nelson, R. R. (1994), “An Introduction to Evolutionary Theories in Economics”, Journal of Evolutionary Economics 4, 153-172.

Hayat, A. andMishra, S. (2010), “Federal ReserveMonetary Policy and the Non-linearity of the Taylor Rule”, Economic Modelling 27, 1292-1301.

Klose, J. (2011), “Asymmetric Taylor Reaction Functions of the ECB: An Approach Depending on the State of the Economy”, The North American Journal of Economics and Finance 22, 149-163.

Kulikauskas, D. (2014), “Nonlinear Taylor Rule for the European Central Bank”, Economics Bulletin 34, 1798-1804.

Lee, D. J. and Son, J. C., (2013), “Nonlinearity and Structural Breaks in Monetary Policy Rules with Stock Prices”, Economic Modelling 31, 1-11.

Leeper, E. M. (1991), “Equilibria under ‘Active’ and ‘Passive’ Monetary and Fiscal Policies”, Journal of Monetary Economics 27, 129-147.

Leeper, E. M. and Leith, C. (2016), “Understanding Inflation as a Joint Monetary-Fiscal Phenomenon”, in Taylor, J. B. and Uhlig, H. (Eds.), Handbook of Macroeconomics 2, Amsterdam: North-Holland/Elsevier, 2305-2415.

Legrenzi, G. and Milas, C. (2012a), “Nonlinearities and the Sustainability of the Government’s Intertemporal Budget Constraint”, Economic Inquiry 50, 988-999.

Legrenzi, G. and Milas, C. (2012b), “Fiscal Policy Sustainability, Economic Cycle and Financial Crises: The Case of the GIPS”, Working Paper Series 54-12, The Rimini Centre for Economic Analysis.

Legrenzi, G. and Milas, C. (2013), “Modelling the Fiscal Reaction Functions of the GIPS Based on State-varying Thresholds”, Economics Letters 121, 384-389.

Ma, Y. (2016), “Nonlinear Monetary policy and Macroeconomic Stabilization in Emerging Market Economies: Evidence from China”, Economic Systems 40, 461-480.

Martin, M. and Milas, C. (2004), “Modelling Monetary Policy: Inflation Targeting in Practice”, Economica 71, 209-221.

Miles, W. and Schreyer, S. (2012), “Is Monetary Policy Non-linear in Indonesia, Korea, Malaysia, and Thailand? A Quantile Regression Analysis”, Asian-Pacific Economic Literature 26, 155-166.

Miles, W. and Schreyer, S. (2014), “Is Monetary Policy Non-linear in Latin America? A Quantile Regression Approach to Brazil, Chile, Mexico and Peru”, Journal of Developing Areas 48, 169-183.

Naraidoo, R. and Paya, I. (2014), “Forecasting Monetary Policy Rules in South Africa”, International Journal of Forecasting 28, 446-455.

Nelson, R. R. and Winter, S. (1982), An Evolutionary Theory of Economic Change, Belknap Press, Cambridge.

Neuenkirch, M. and Tillmann, P. (2014), “Inflation Targeting, Credibility, and Non-linear Taylor Rules”, Journal of International Money and Finance 41, 30-45.

Petersen, K. B. (2007), “Does the Federal Reserve Follow a Non-linear Taylor Rule?”, Working Paper 2007-37 University of Connecticut, Department of Economics.

Piergallini, A. (2016), “A Note on Nonlinear Fiscal Regimes and Interest Rate Policy”, Macroeconomic Dynamics 20, 832-844.

Piergallini, A. and Postigliola, M. (2013), “Non-linear Budgetary Policies: Evidence from 150 Years of Italian Public Finance”, Economics Letters 121, 495-498.

Radzicki, M. L. and Sterman, G. D. (1994), “Evolutionary Economics and System Dynamics”, in England, R. W. (ed.), Evolutionary Concepts in Contemporary Economics, Ann Arbor, MI: University of Michigan Press.

Ramsey, F. P. (1928), “A Mathematical Theory of Saving”, Economic Journal 38, 543-559.

Reis, R. (2007), “The Analytics of Monetary Non-Neutrality in the Sidrauski Model”, Economics Letters 94, 129-135.

Rotemberg, J. J. (1982), “Sticky Prices in the United States”, Journal of Political Economy 90, 1187-1211.

Sarno, L. (2001), “The Behavior of US Public Debt: A Nonlinear Perspective”, Economics Letters 74, 119-125.

Shen, C.-H., Lin, K.-L. and Guo, N. (2016), “The Hawk or Dove: Switching Regression Model for the Monetary Policy Reaction Function in China”, Pacific-Basin Finance Journal 36, 94-111.

Sznajderska, A. (2014), “Asymmetric Effects in the Polish Monetary Policy Rule”, Economic Modelling 36, 547-556.

Taylor, J. B. (1993), “Discretion Versus Policy Rules in Practice”, Carnegie-Rochester Conference Series on Public Policy 39, 195-214.

Taylor, M. P. and Davradaki, E. (2006), “Interest Rate Setting and Inflation Targeting: Evidence of a Nonlinear Taylor Rule for the United Kingdom”, Studies in Nonlinear Dynamics and Econometrics 10, 1-20.

Woodford, M. (2003), Interest and Prices, Princeton and Oxford: Princeton University Press.