Fiscal Origins of Monetary Paradoxes

Dejanir Silva, Nicolas Caramp

Research output: Working paper

Abstract

We revisit the monetary paradoxes of standard monetary models in a liquidity trap and study the channels through which they occur. We focus on two paradoxes: the Forward Guidance Puzzle and the Paradox of Flexibility. First, we propose a decomposition of consumption into substitution and wealth effects, both of which take into account the general equilibrium effects on output and inflation, and we show that the substitution effect cannot account for the puzzles. Instead, monetary paradoxes are the result of strong wealth effects which, generically, are solely determined by the expected fiscal response to the monetary shocks. We estimate the fiscal response to monetary policy shocks and find responses with the opposite sign to the ones implied by the standard equilibrium. Finally, we introduce the estimated fiscal responses into a medium-size DSGE model. We find that the impulse-response of consumption and inflation do not match the data, suggesting that wealth effects induced by fiscal policy are important even outside of the liquidity trap.
Original languageEnglish (US)
Number of pages62
StatePublished - Mar 19 2018

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