Wavelet-based monetary and fiscal policy in the Euro area

Patrick Crowley and David Hudgins

Journal of Policy Modeling, 2017, vol. 39, issue 2, 206-231

Abstract: This paper first applies the MODWT (Maximal Overlap Discrete Wavelet Transform) to Euro area quarterly GDP data from 1995 to 2014 to obtain the underlying cyclical structure of the GDP components. We then design optimal fiscal and monetary policy within a large state-space LQ-tracking wavelet decomposition model. Our study builds a MATLAB program that simulates optimal policy thrusts at each frequency range where: (1) both fiscal and monetary policy are emphasized, (2) only fiscal policy is relatively active, and (3) when only monetary policy is relatively active. The results show that the monetary authorities should utilize a strategy that influences the short-term market interest rate to undulate based on the cyclical wavelet decomposition in order to compute the optimal timing and levels for the aggregate interest rate adjustments. Given that central bank rates are adjusted in discrete steps, this implies that central bank monetary policy adjustments will be sub-optimal. We also find that modest emphasis on active interest rate movements can alleviate much of the volatility in optimal government spending, while rendering similarly favorable levels of aggregate consumption and investment. This research is the first to construct joint fiscal and monetary policies in an applied optimal control model based on the short and long cyclical lag structures obtained from wavelet analysis.

Keywords: Discrete wavelet analysis; Fiscal policy; Monetary policy; Optimal control (search for similar items in EconPapers)
JEL-codes: C49 C61 C63 C88 E52 E61 (search for similar items in EconPapers)
Date: 2017
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (14)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jpolmo:v:39:y:2017:i:2:p:206-231

DOI: 10.1016/j.jpolmod.2017.01.005

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