Inflation Targeting with a Fiscal Taylor Rule

Orientador(a): Yvan Becard

Most national governments use the short-term interest rate as the main tool to stabilize the economy, raising the rate to contain upward pressures on inflation or output and lowering it when the opposite is needed. This framework has worked well in many places and periods but not everywhere nor all the time. Governments that were led to maintain high interest rates for long periods paid a high budgetary cost for it, and since 2008 many countries found themselves constrained by the effective lower bound. This work aims to study an alternative inflation targeting regime where the interest rate is kept constant and the consumption tax rate is used as the stabilizing tool that reacts to inflation and to the output gap, which we call a fiscal Taylor rule (FTR). Using a standard medium-scale DSGE model, we obtain Bayesian estimates of parameters and shocks to closely replicate the main macroeconomic variables of the US economy during the Great Moderation period (1985-2007) assuming a standard Taylor rule was in place, and we apply these estimated shocks to the model where the standard Taylor rule is replaced by the FTR. We find that compared to the standard Taylor rule, the FTR is capable of providing similar performance in terms of economic stabilization and thus constitutes a theoretically viable option for policy framework