August 1989

Policy Rules, Information, and Fiscal Effects in a "Ricardian" Model

Eric M. Leeper


According to conventional wisdom, if deficits are inflationary then current deficits should predict subsequent movements in money growth. This paper USES a general equilibrium model fit to data to: (1) explore the policy behavior underlying this accepted viewpoint; (2) examine alternative equi­librium deficit policies ranging from an exclusive reliance on direct lump-sum taxes to a mix of direct and inflation taxes; and (3) evaluate the empirical trade-offs implied by the various financing schemes. The results suggest that reduced-form analyses of whether "deficits matter" can lead to seriously misleading conclusions by mistakenly attributing fiscal effects to monetary policy.

I demonstrate that simple monetary and tax policy rules and plausible assumptions about when private agents learn of fiscal actions can produce a classical economy whose nominal equilibrium depends on the process for lump­sum taxes and whose time series contradict the view that monetized deficits predict inflation. I assess the fit of versions of the model to U.S. data and reinterpret existing reduced-form studies in light of the results.

PDF: Full Paper

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Last Update: March 30, 2021