Dynamics of fiscal financing in the United States

General equilibrium models that include policy rules for government spending, lump-sum transfers, and distortionary taxation on labor and capital income and on consumption expenditures are fit to US data under rich specifications of fiscal policy rules to obtain several results. First, the best-fitting model allows many fiscal instruments to respond to debt. Second, responses of aggregates to fiscal policy shocks under rich rules vary considerably from responses where only non-distortionary fiscal instruments finance debt. Third, in the short run, all fiscal instruments except labor taxes react strongly to debt, but long-run intertemporal financing comes from all components of the government’s budget constraint. Fourth, debt-financed fiscal shocks trigger long-lasting dynamics; short-run and long-run multipliers can differ markedly.     

Impacts of Monetary, Fiscal and Exchange Rate Policies on Output in China: A Var Approach

Applying the VAR model and using the interest rate as a monetary policy variable, we find that in the long run, output in China responds negatively to a shock to the interest rate, the real exchange rate, government debt, or the inflation rate, and it reacts positively to a shock to government deficits or lagged own output. When real M2 is chosen as a monetary policy variable, long-term output in China responds positively to a shock to real M2 or lagged own output, and it reacts negatively to a shock to the real exchange rate, government debt, or government deficits. Its response to a shock to the inflation rate is negative when government debt is used and is positive when government deficits are considered. In the short run, fiscal policy is more important than monetary policy in three out of four cases. In the long run, monetary policy is more influential than fiscal policy in three out of four cases. Therefore, the government may consider conducting monetary and fiscal policies differently in the short run and long run. The government needs to be cautious in pursuing deficit spending as its long-term impacts depend on the monetary variable employed. The policy of maintaining a relatively stable exchange rate is appropriate as the depreciation of the Yuan may hurt the economy in the short run.JEL Classifications: E5, F4, H6     

Briefing Paper: The Interdependence of Fiscal and Monetary Policy under Economic and Monetary Union

This article explores the implications of Economic and Monetary Union (EMU) for the conduct of fiscal policy. Under EMU, where the European Central Bank is successful in controlling inflation, the loss of seigniorage revenues causes a potential problem for public sector deficits. To prevent the debt-income ratio from spiralling upwards, a primary budget surplus is ultimately required. EMU has usually been considered as a strong central monetary authority which forces fiscal discipline on lax national governments. But this is not the only possibility. Because the debt ratio can be reduced by surprise inflation, the price expectations of the private sector are important. Once these are taken into account, EMU can be examined in a 'game' framework in which the reputation of the authorities and the existence or otherwise of cooperation between the fiscal and monetary authorities becomes a critical factor.
The paper finds that where the authorities enjoy reputation and cooperate, a one-off reduction in public spending will lead to a permanent decline in the real interest rate and crowd in extra private spending (consumption and investment). Without reputation the cut in government spending has to be sustained. Where there is neither reputation nor cooperation, the outcome depends on the structure of the European economy and whether fiscal policy can effect the terms of trade between countries. If the terms of trade remain unchanged, the outturn is similar to the case of cooperation without reputation, but where the terms of trade can be improved in one country, there is no incentive to cut public spending. In this case the outturn is higher inflation with private spending crowded out.     

Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy

How does the need to preserve government debt sustainability affect the optimal monetary and fiscal policy response to a liquidity trap? To provide an answer, we employ a small stochastic New Keynesian model with a zero bound on nominal interest rates and characterize optimal time-consistent stabilization policies. We focus on two policy tools, the short-term nominal interest rate and debt-financed government spending. The optimal policy response to a liquidity trap critically depends on the prevailing debt burden. While the optimal amount of government spending is decreasing in the level of outstanding government debt, future monetary policy is becoming more accommodative, triggering a change in private sector expectations that helps to dampen the fall in output and inflation at the outset of the liquidity trap.     

Growth, debt and public infrastructure

This paper presents a closed economy model of endogenous growth driven by capital externalities arising from both private capital and public infrastructure. The model is calibrated to fit data for India, an approximately closed economy. Simulations suggest that fiscal policy certainly matters and the choice of the income taxation rate, the mix of government spending between infrastructure and public consumption goods, and the long-run government debt/GDP ratio can all significantly affect the long-run growth rate. Intertemporal aspects of fiscal policy are also important and the precommitment (time-inconsistent) and non-precommitment policies differ substantially.     

Optimal fiscal policy under learning

This paper characterizes optimal fiscal policy when agents learn about future taxation. A benevolent and fully rational government chooses taxes on labor income and state-contingent bonds to finance public spending, considering that private agents form their expectations through a learning algorithm. Facing a trade-off between distortionary taxes and distorted expectations, the Ramsey planner chooses the policy that minimizes the total cost of distortions. The analysis produces two main results. First, the government will use fiscal variables to manipulate expectations, reducing taxes and issuing debt at times of pessimism and doing the opposite at times of optimism. This speeds up learning. Second, the expectation-dependent fiscal plan is also history-dependent, and it prescribes taxes that are not as smooth and more persistent than under rational expectations. These findings are robust to alternative learning algorithms.     

The Paradoxes and Pitfalls of Revived Fiscal Activism

This paper critiques the revival of fiscal activism by the G20 in response to the global financial crisis of 2008–9. It first re‐examines the international macroeconomic conditions leading up to that crisis, before highlighting the paradoxes and pitfalls of revived fiscal activism for advanced economies. It argues that the harmful legacy of budget deficits and escalated public debt levels spawned further financial crises, most notably in southern Europe, and generally damaged household and business confidence to the detriment of private consumption and investment spending, which has delayed economic recovery. To undertake the repair necessary to the fiscal accounts of most advanced economies, the paper proposes that government spending programmes need to be thoroughly reviewed against the key principles of public finance.     

中国财政政策规则及其体制稳定性分析

本文构建了内生捕捉我国财政政策体制变化的财政规则,并对产出缺口稳定动机和债务稳定动机反应进行了分析。基于马尔科夫转换财政政策反馈规则的实证估计表明,不同体制下,财政赤字与政府债务和产出缺口之间存在不同的政策反应关系;与基于不变参数识别的规则相比,体制转换财政规则能更好地追踪我国财政赤字的时间序列行为。这意味着,假定财政政策体制总是固定的货币政策规则研究以及基于不变财政体制框架VAR度量财政政策冲击高频率效应的实证研究都应慎重。     

Monetary and fiscal policy under deep habits

Allowing habits to be formed at the level of individual goods – deep habits - can radically alter the fiscal policy transmission mechanism as the counter-cyclicality of mark-ups this implies can result in government spending crowding-in rather than crowding-out private consumption in the short run. We explore the robustness of this mechanism to the existence of price discrimination in the supply of goods to the public and private sectors. We then describe optimal monetary and fiscal policy in our New Keynesian economy subject to the additional externality of deep habits and explore the ability of simple policy rules to mimic fully optimal policy. We find that the presence of deep habits at empirically estimated levels can imply large externalities that significantly affect the conduct of monetary and tax policy. However, despite the rise in government spending multipliers implied by deep habits, government spending is barely used as a stabilisation tool under the optimal policy.     

Policy uncertainty and aggregate fluctuations

This paper estimates the impact on the US economy of four types of uncertainty about (i) government spending, (ii) tax changes, (iii) public debt, and (iv) monetary policy. Uncertainty about government debt has a large and persistent effect on output, consumption, investment, consumer confidence, and business confidence. Uncertainty about tax changes also has detrimental consequences for real activity but the effect of spending and monetary policy uncertainty appears to be small. About 25% of output fluctuations are accounted for by policy uncertainty, with government debt making the largest contribution at longer horizons.     

Local fiscal multipliers and spillover effects: Evidence from Philippine regions

Fiscal policy in developed countries has been a rich topic since the Great Recession. However, research has remained limited for developing countries despite their similar use of fiscal policy and concerns about the efficiency of public spending. To help address this research gap, this paper provides a case study of multiplier effects of local government spending in regions in the Philippines as well as spillover effects of local government spending across regions. An instrumental variable based on the country’s intergovernmental transfer system is used to identify regional public spending in panel regressions. The local fiscal multiplier is estimated to be above one, where a 1-peso rise in spending by local government units in a region corresponds to a 1.2-peso rise in regional output. Multiplier effects are highest for capital expenditures and appear to be primarily driven by the services sector. Spillover effects are comparatively large, at around 1.8–2.0, highlighting the important role of domestic trade when stimulating regional economic activity.     

Lack of confidence,the zero lower bound,and the virtue of fiscal rules

In the presence of the zero lower bound, standard business cycle models with a Taylor-type monetary policy rule are prone to equilibrium multiplicity. A drop in private sector confidence can drive the economy into a liquidity trap without any change in fundamentals. I show, in the context of a standard New Keynesian model, that it is possible to design Ricardian fiscal spending rules that insulate the economy from such expectations-driven liquidity traps. In the case of price adjustment costs, desirable fiscal rules ensure that a drop in confidence does not lead to a decline in real marginal costs. In the case of nominal wage adjustment costs, desirable fiscal spending rules ensure that a drop in confidence does not lead to a decline in the ratio of the marginal rate of substitution between private consumption and hours worked relative to the real wage rate.     

Fiscal consolidation and its cross-country effects

We build a new Keynesian DSGE model consisting of two heterogeneous countries in a monetary union. We study how public debt consolidation in a country with high debt (like Italy) affects welfare in a country with solid public finances (like Germany). Our results show that debt consolidation in the high-debt country benefits the country with solid public finances over all time horizons, while, in Italy, debt consolidation is productive in the medium and long term. All this is with optimized feedback policy rules. On the other hand, fiscal consolidation hurts both countries and all the time, if it is implemented in an ad hoc way, like an increase in taxes. The least distorting fiscal mix from the point of view of both countries is the one which, during the early phase of pain, Italy cuts public consumption spending to address its debt problem and, at the same time, reduces income tax rates, while, once its debt has been reduced in the later phase, it uses the fiscal space to further cut income taxes.     

Will Labour’s Economic Programme Work?

If Labour is elected to government on 1 May, it will inherit the lowest inflation of any incoming government over the last fifty years but the highest unemployment. At the same time, public borrowing is running at an unsustainable high level. In this article, Andrew Sentance examines Labour's plans to expand employment while reducing public borrowing and containing inflation. He argues that Labour's economic programme could work but a number of pitfalls need to be avoided. Monetary policy will need to be tightened after the Election and the fiscal squeeze implied by Conservative spending plans maintained – if necessary through higher taxes. The benefits from Labour's employment policies could also be undermined by a high minimum wage, particularly if applied to young workers.     

Pushing the limit? Fiscal policy in the European Monetary Union

Governments are confronted with the growing realization that they face fiscal limits on the size of debt and deficits relative to GDP. These fiscal limits invalidate Bohn's criterion for fiscal sustainability, which allows explosive debt relative to GDP, eventually violating any fiscal limit. We derive restrictions on a fiscal rule, necessary for the government to eliminate explosive behavior. These restrictions require that the response of the primary surplus to debt be relatively strong, and that the primary surplus be cointegrated with both debt and output. We test these empirical implications for a panel of eleven EMU countries, and find that they are satisfied, implying that fiscal policy does not create explosive behavior.     

Managing the Public Debt: The Optimal Taxation Approach

This paper examines research on public debt management, focusing on debt structure by denomination, indexation features, and maturity. The optimal taxation approach is reviewed and its policy implications are related to the trade-off between minimization of the expected cost of debt servicing and minimization of budgetary risk. Strong arguments are provided for debt instruments which yield low returns when output and hence revenues are lower and public spending higher than expected. This debt design minimizes tax distortions and provides flexibility in conducting fiscal policy. The exact characterization of the debt composition which supports efficient taxation depends on the stochastic structure of the economy. Long-term nominal debt is a hedge against supply shocks affecting revenues and inflation and makes the government budget insensitive to interest-rate risk. However, at high levels of debt, the extent of insurance or flexibility that governments can obtain by issuing long-term nominal debt is limited by the need to maintain the credibility of the anti-inflation stance.     

Fiscal and monetary interdependence

Where classical economics integrates the quantity theory of money with the concept of Ricardian equivalence, the tendency of recent macroeconomic presentations is to focus either upon money and inflation or upon taxation and debt. That neglect of classical monetary–fiscal integration is surprising, given an initiative by the International Monetary Fund that set credit, money, and fiscal policy within a single structure. This article places those ‘credit counterparts of broad money’ in the context of the Great Depression and the recent global financial crisis. The upshot is a set of conclusions: that, to counter the prospect of deflation, quantitative easing is a weak policy response; that fiscal deficits are better; and that cuts in taxation are preferable to increased government spending.     

What are the effects of fiscal policy shocks?

We propose and apply a new approach for analyzing the effects of fiscal policy using vector autoregressions. Specifically, we use sign restrictions to identify a government revenue shock as well as a government spending shock, while controlling for a generic business cycle shock and a monetary policy shock. We explicitly allow for the possibility of announcement effects, i.e., that a current fiscal policy shock changes fiscal policy variables in the future, but not at present. We construct the impulse responses to three linear combinations of these fiscal shocks, corresponding to the three scenarios of deficit‐spending, deficit‐financed tax cuts and a balanced budget spending expansion. We apply the method to US quarterly data from 1955 to 2000. We find that deficit‐financed tax cuts work best among these three scenarios to improve GDP, with a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue 5 years after the shock. Copyright © 2009 John Wiley & Sons, Ltd.     

General Election: How would the parties' plans impact the outlook?

• Our modelling suggests that, based upon the three main parties’ economic and fiscal plans, the outcome of the General Election would have a modest, but not immaterial, impact on the UK's economic and fiscal outlook. The Liberal Democrat plans would deliver the strongest GDP growth, followed by Labour, but both would also involve higher debt servicing costs and a higher level of government debt than the plans of the Conservatives.
• In our view these premiums on debt and borrowing costs are so small that it is very difficult to argue that the UK should pursue a more austere fiscal policy and reject the opportunity of stronger growth. But with the latest opinion polls suggesting that it is likely that the next government will be either a minority administration, or a coalition consisting of three or more parties, it is most likely that we will ultimately see some combination of the main parties' plans enacted.
• The experience of 2010 suggests that such political uncertainty could mean that we see several bouts of market nervousness between now and May 7th, particularly in equity markets. However, such turbulence is likely to be short‐lived, providing that the resulting government is perceived to be strong and durable. Even a multi‐party coalition may not be such a bad thing, particularly if it watered down the more contentious policies of the main parties. The worst‐case scenario would be a weak minority government which is both unable to pass any meaningful legislation and unable to seek a fresh mandate. Such a scenario could seriously undermine confidence amongst investors and firms.

     

Economic Outlook 1985- 1989: The London Business School with Gower Publishing: Forecast Release: THE AUTUMN STATEMENT: IF YOU CAN'T BEAT 'EM

In announcing significant increases in public spending in the Autumn Statement, the government has recognised that the scope for further interest rate reductions ahead of the election is virtually nil. It has therefore sought to boost demand, and its own popularity, by a fiscal relaxation. It so doing, it is prepared to risk a PSBR. (excluding privatization) of £27bn, exactly in line with the estimates which we made in June of Labour Party policy. In terms of macroeconomic policy, therefore, the gap between the two parties is virtually closed, while that between Mr. Major's government and that of Mrs. Thatcher is evident. Front this starting point, we argue that honouring Mr. Laniont's pledge on income tax could be at the expense of removing tax relief on mortgage interest payments and that a Labour government which still cherishes higher public spending may be forced into continuing the privatization programme. Under either Party there is a strong political case for tax increases, or for rescinding some of the planned increase in spending, early in the life of the next Parliament in order to bring the economic and political cycles back into synchronisation from which they were disturbed by Mr. Lawson's tax-cutting Budget of 1988.