The combination of monetary and fiscal policy shocks : a TVP-FAVAR approach

Abstract

This paper analyzes jointly the effects of monetary and fiscal policy shocks in the US economy using a factor augmented vector autoregressive model with drifting coefficients and stochastic volatility. The time varying structure of the model allows to assess the impact of monetary policy shocks in the same periods when fiscal policy shocks identified via the narrative approach are also at play. In this way we study how the monetary policy transmission changes conditional on expansionary or contractionary exogenous fiscal policies, which are determined by the discretionary intervention of the fiscal authority and are not the response of business cycle fluctuations or the reaction to monetary policy. We find that fiscal policy strongly affects the impulse responses to monetary policy shocks through the aggregate demand channel. These results are relevant to understand the implications of different policy mixes.