Optimal fiscal policy under multiple equilibria

We study optimal fiscal policy in an economy where (i) search frictions create a coordination problem and generate multiple, Pareto-ranked equilibria and (ii) the government finances the provision of a public good by taxing market activity. The government must choose the tax rate before it knows which equilibrium will obtain, and therefore an important part of the problem is determining how the policy will affect the equilibrium selection process. We show that when the equilibrium selection rule is based on the concept of risk dominance, higher tax rates make coordination on the Pareto-superior outcome less likely. As a result, taking equilibrium-selection effects into account leads to a lower optimal tax rate.     

Accrual accounting and Australian fiscal policy

Australian governments have recently moved from cash accounting to accrual accounting. Accrual accounting has been accompanied at the national government level by the introduction of a new key fiscal policy measure: the ‘fiscal balance’. This paper explains and evaluates this new fiscal measure. It concludes that, given the present fiscal policy of the Australian government, fiscal balance is a superior fiscal policy measure to the ‘cash’ budget balance measure which it replaced. However, from the alternative ‘golden rule’ policy standpoint, fiscal balance is not a meaningful fiscal policy measure — although its stock counterpart, net financial liabilities, certainly is.     

Interaction of Government Tiers and Central Banks in a Federation: An Empirical Test

Fiscal rules are necessary to protect monetary policy from the consequences of unsustainable or active fiscal policy for inflation. Monetary unions, such as the Economic and Monetary Union (EMU), require even stronger fiscal rules to avoid free riding by regional fiscal authorities on the common monetary policy. By contrast, in a fiscal federation, the federal government internalises the effect of active regional policies on the overall price level. Federal fiscal policy contributes to price stability either by enforcing fiscal rules or by adjusting its own stance. Following Canzoneri, Cumby and Diba (2001), we test whether federal and regional governments in Germany behave in an active or passive way. We find evidence of a spillover effect of unsustainable policies on other regions. The German federal government offsets the effect on the price level by running passive policies. The Bundesbank's prime objective of price stability is therefore endorsed by fiscal policy. The results have implications for the regulation of fiscal policies in the EMU.     

Optimal fiscal and monetary policy with sticky prices

In this paper I consider the role of state-contingent inflation as a fiscal shock absorber in an economy with nominal rigidities. I study the Ramsey equilibrium in a monetary model with distortionary taxation, nominal non-state-contingent debt, and sticky prices. With sticky prices, the Ramsey planner must balance the shock absorbing benefits of state-contingent inflation against the associated resource misallocation costs. For government spending processes resembling post-war experience, introducing sticky prices generates striking departures in optimal policy from the case with flexible prices. For even small degrees of price rigidity, optimal policy displays very little volatility in inflation. Tax rates display greater volatility compared to the model with flexible prices. With sticky prices, tax rates and real government debt exhibit behavior similar to a random walk. For government spending processes resembling periods of intermittent war and peace, optimal policy displays extreme inflation volatility even when the degree of price rigidity is large. As the variability in government spending increases, smoothing tax distortions across states of nature becomes increasingly important, and the shock absorber role of inflation is accentuated.     

Fiscal hedging with nominal assets

We analyze optimal fiscal and monetary policy in an economy with distortionary labor income taxes, nominal rigidities, nominal debt of various maturities and short-selling constraints. Optimal policy prescribes the almost exclusive use of long term debt. Such debt mitigates the distortions associated with hedging fiscal shocks by allowing the government to allocate them efficiently across states and periods.     

On the irrelevance of government debt when taxes are distortionary

We consider a government that can only raise funds by levying distortionary taxes. We allow the government to collect taxes in a given period that are based on incomes earned in previous periods. We show that once we do so, given any debt path, the government can adjust its tax policy so as to attain that debt path without affecting equilibrium allocations or prices.     

Simple Monetary Rules under Fiscal Dominance

This paper asks whether interest rate rules that respond aggressively to inflation, following the Taylor principle, are feasible in countries that suffer from fiscal dominance. We find that if interest rates are allowed to also respond to government debt, they can produce unique equilibria. But such equilibria are associated with extremely volatile inflation. The resulting frequent violations of the zero lower bound make such rules infeasible. Even within the set of feasible rules the welfare optimizing response to inflation is highly negative. The welfare gain from responding to government debt is minimal compared to the gain from eliminating fiscal dominance.     

Sovereign risk premiums in the European government bond market

This paper provides a study of bond yield differentials among EU government bonds on the basis of a unique data set of issue spreads in the US and DM (Euro) bond market between 1993 and 2009. Interest differentials between bonds issued by EU countries and Germany or the USA contain risk premiums which increase with fiscal imbalances and depend negatively on the issuer’s relative bond market size. The start of the European Monetary Union has shifted market attention to deficit and debt service payments as key measures of fiscal soundness and eliminated liquidity premiums in the euro area. With the financial crisis, the cost of loose fiscal policy has increased considerably.     

Spending Reversals and Fiscal Multipliers under an Interest Rate Peg

This paper examines whether fiscal stimuli are more effective when the monetary policy is less responsive to inflation. First, we provide empirical evidence suggesting that, in the period of U.S. passive monetary policy, a positive government spending shock was followed over time by a spending cut. Second, our theoretical analysis reveals that the pegged nominal interest rate is not a sufficient condition to generate a large fiscal multiplier. An increase in government spending could increase the long‐run real interest rate, if it is associated with a government spending reversal and a less responsive monetary policy. Consequently, the response of private consumption can be negative and the government spending multiplier is not necessarily greater than 1.     

On the time-consistency of optimal capital taxes

This paper studies the time-inconsistency problem of optimal capital taxes. In the absence of full-commitment, it is well known that debt restructuring cannot solve the time-inconsistency problem for economies with a private stock of capital. We re-examine this result by exploring the role of institutional delays in government policies. We show that, when the implementation of government policy requires time, debt restructuring can enforce commitment to the optimal capital taxes. We conclude that, since institutional delays characterize democratic decision making, the time-inconsistency problem of capital taxes is not so severe.     

Optimal simple and implementable monetary and fiscal rules

Welfare-maximizing monetary- and fiscal-policy rules are studied in a model with sticky prices, money, and distortionary taxation. The Ramsey-optimal policy is used as a point of comparison. The main findings are: the size of the inflation coefficient in the interest-rate rule plays a minor role for welfare. It matters only insofar as it affects the determinacy of equilibrium. Optimal monetary policy features a muted response to output. Interest-rate rules that feature a positive response to output can lead to significant welfare losses. The welfare gains from interest-rate smoothing are negligible. Optimal fiscal policy is passive. The optimal monetary and fiscal rule combination attains virtually the same level of welfare as the Ramsey-optimal policy.     

Financial Crisis, Fiscal Policy, and the 1995 GDP Contraction in Mexico

In 1995 Mexico experienced its largest contraction of gross domestic product (GDP) since the early twentieth century. I propose a simple mechanism to partially account for the contraction: the effects of changes in fiscal policy. The contraction of GDP was preceded by a financial crisis. The government responded by raising taxes and reducing spending. Using a model with taxation and government consumption, and the business cycle accounting methodology, I measure the impact of fiscal policy. Fiscal policy accounts for 20.7% of the fall in output.     

Assessing long-term fiscal developments: A new approach

We use a new approach to assess long-term fiscal developments. By analyzing the time-varying behaviour of the two components of government spending and revenue - responsiveness and persistence -, a feature not captured by automatic stabilisers, we are able to infer about the sources of fiscal deterioration (improvement). Drawing on quarterly data, we estimate recursively these components within a system of government revenue and spending equations using a Three-Stage Least Square method for eight European Union countries plus the US. The results suggest that significant changes in the fiscal stance (including those related to the current crisis) are reflected in the estimates of persistence and responsiveness.     

Level,slope, curvature of the sovereign yield curve,and fiscal behaviour

We study fiscal behaviour and the sovereign yield curve in the US and Germany. We obtain the latent factors, level, slope and curvature, with the Kalman filter, and use them in a VAR with macro, fiscal and financial stress variables. In the US, fiscal shocks generate an immediate response of the short-end of the yield curve, associated with monetary policy, lasting 6–8 quarters, followed by a response of the whole yield curve lasting 3 years, with an implied elasticity of long-term yields of 80% for the government debt shock and 48% for the budget balance shock. In Germany, fiscal shocks have entailed no significant reactions of the yield curve shape and no response of the monetary policy interest rate, notably after 1999; only in the case of debt shocks there is a short-lived decrease in the medium-end of the yield curve in the following 2nd and 3rd quarters.     

Cyclically‐Neutral Generational Accounting

This paper introduces a key methodological innovation into generational accounting. By incorporating cyclically‐adjusted balances into the forward‐looking budget projections underlying the concept, we isolate pure policy effects, which render comparisons of the fiscal sustainability indicators obtained across time and countries truly meaningful. We also show that a demographic effect and a debt effect may drive fiscal sustainability measures over time, and establish a routine to control for these effects in the generational accounting framework. An empirical application for Spain illustrates that our proposed decomposition of indicators is empirically relevant. Standard generational accounting suggests that fiscal sustainability in Spain improved substantially in preparing for EMU. However, calculation of the pure policy effects reveals that this has not been the case.     

Strengthening Post‐Crisis Fiscal Credibility: Fiscal Councils on the Rise – A New Dataset

Institutions that aim to constrain policy discretion in order to promote sound fiscal policies are once again at the forefront of the policy debate. Interest in fiscal councils – independent watchdogs active in the public debate – has grown rapidly in recent years. In this paper, we present the first cross‐country dataset summarising key characteristics of fiscal councils among International Monetary Fund members. The data document a surge in the number of fiscal councils since the 2008–09 economic and financial crisis, and also illustrate that well‐designed fiscal councils are associated with stronger fiscal performance and better macro‐economic and budgetary forecasts. Key features of effective fiscal councils include operational independence from politics, the provision or public assessment of budgetary forecasts, a strong presence in the public debate and the monitoring of compliance with fiscal policy rules.     

Fiscal shocks and real exchange rate dynamics: Some evidence for Latin America

This paper analyses the effects of fiscal shocks in selected Latin American countries using a two-country model for output, labour input, government spending and relative prices. Dynamic simulation techniques are then applied, in particular to shed light on the possible effects of fiscal imbalances on the real exchange rate. Using quarterly data over the period 1980-2006, we find that in a majority of cases fiscal shocks are the main driving force of real exchange rate fluctuations.     

Optimal Fiscal Policy Rules in a Monetary Union

This paper investigates the importance of fiscal policy in providing macroeconomic stabilization in a monetary union. We use a microfounded New Keynesian model of a monetary union, which incorporates persistence in inflation and non-Ricardian consumers, and derive optimal simple rules for fiscal authorities. We find that fiscal policy can play an important role in reacting to inflation, output, and the terms of trade, but that not much is lost if national fiscal policy is restricted to react, on the one hand, to national differences in inflation and, on the other hand, to either national differences in output or changes in the terms of trade. However, welfare is reduced if national fiscal policy responds only to output, ignoring inflation.     

Optimal money and debt management: Liquidity provision vs tax smoothing

Conventional wisdom on public debt management says that liquidity demand should be satiated and that tax rates should be smoothed. Conflicts between the two can arise when government bonds provide liquidity. Smoothing taxes causes greater variability in fiscal balances, and therefore in the supply of government liabilities. When prices are flexible, and can jump to absorb fiscal shocks, the tradeoff between liquidity provision and tax smoothing is eased; when they conflict, optimal policy subordinates tax smoothing to satiating liquidity demand. When price fluctuations impose real costs, conflicts necessarily arise and optimal policy gives primacy to neither goal.     

Identifying Discretionary Fiscal Policy Reactions with Real‐Time Data

We propose a method of identifying discretionary fiscal policy reactions using real‐time data. Automatic stabilizers should depend on true GDP, while discretionary fiscal policy is contingent on the information that policy makers have in real time. We can compute a real‐time measurement error by comparing the first release of GDP data with later revisions. Discretionary fiscal policy is influenced by this measurement error, whereas automatic fiscal policy is not. We use this identification approach to test the central identifying assumption of Blanchard and Perotti’s (2002) seminal structural vector autoregression (VAR). According to this assumption, fiscal policy makers do not react to GDP developments contemporaneously in a discretionary fashion. We find that government expenditure is adjusted upward if GDP growth in real time is lower than true GDP. This suggests that fiscal policy makers use short‐term funds to buy goods and services in response to their perception of GDP dynamics.