Stabilization effects of policy rules

Abstract

The stabilization effects of fiscal and monetary policy in the context of dynamic macroeconomic models with rational expectations differ from the effects in traditional Keynesian models. In the rational expectations setting, if a policy rule eliminates multiplicity of equilibrium, that policy stabilizes the economy in the sense that it excludes sunspot-driven business fluctuations. Conversely, if a policy rule gives rise to equilibrium indeterminacy, that policy destabilizes the economy. Roughly speaking, if a policy rule stabilizes a Keynesian model with backward-looking expectations, the same policy often generates indeterminacy in the equilibrium models with rational expectations.