Research Discussion Papers, Bank of Finland
Euro area monetary and fiscal policy tracking design in the time-frequency domain
() and David Hudgins
Abstract: This paper first applies the MODWT (Maximal Overlap
Discrete Wavelet Transform) to Euro Area quarterly GDP data from 1995 –
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. 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; euro area; fiscal policy; LQ tracking; monetary policy; optimal control; (follow links to similar papers)
JEL-Codes: C49; C61; C63; C88; E52; E61; (follow links to similar papers)
47 pages, August 12, 2015
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