Finite Horizons and the Monetary/Fiscal Policy Mix

Fiscal policy in the United States has been documented to have been the leading authority in the '70s (active fiscal policy), while having switched to fiscal discipline following Volcker's appointment (passive fiscal policy) onward. Most papers in the literature focus on taxes as the main instrument to stabilize debt when fiscal policy is passive. I extend the existing analysis by also allowing federal spending to adjust. I construct a New Keynesian Markov-switching DSGE model with a Blanchard-Yaari structure and estimate it for the United States. I find that the U.S. economy has switched regimes over time. In line with the existing literature, I show that the economy spent the '70s in a regime where fiscal policy was active while monetary policy was passive. Interestingly, I show that the economy spent a short period in the early '80s where both policies were passive, before switching to a persistent regime where monetary policy has been fighting inflation aggressively and fiscal policy ensured that both tax revenues and federal spending adjusted to stabilize debt.