Determinacy and Learning with Monetary and Fiscal Policy

The present paper evaluates Taylor-type monetary rules from the perspective of which rules delivers determinacy and learnability of a rational expectations equilibrium. The model is fully microfounded. The closed form solution is explicitly derived. The novelty of the approach taken here consists in the derivation of the learning and determinacy condition when the model is enlarged with the government budget constraint (GBC) and a passive (in the sense proposed by Leeper 1991) fiscal policy rule. The presence of GBC and a passive fiscal rules can help to alleviate the problem of indeterminacy and explosive instability. In this context, fiscal authority can help to restore determinacy of the equilibrium even when monetary policy does not aggressively target the inflation rate. Expectational stability always requires a combination of active monetary - active fiscal policies. This contrasts with the actual European monetary/fiscal policy regime where an active monetary is coupled with passive fiscal policy: it is shown that this combination produces a determinate equilibrium, which is not E-stable.