Energy intensity and directed fiscal policy

This paper assesses the effects of fiscal policy on economy-wide energy intensity within an endogenous growth framework. To this end, we first develop a two-sector (investment good and consumption good) augmented AK model by integrating the Uzawa model with Rebelo’s AK model, and assume that a non-renewable resource is one of the factors of production. Using this framework, we solve the model for the short and long run, identifying the sufficient parameter conditions that ensure higher energy intensity in the investment goods sector. We then introduce a balanced budget government, whose objective is to decrease the economy-wide energy intensity by levying tax on the energy-intensive investment goods sector and subsidizing the consumption goods sector. Contrary to our expectations, we find that this fiscal policy design increases economy-wide energy intensity as it leads to a decline in real GDP without changing total energy consumption. On the basis of this model, we propose the concept of a ‘directed fiscal policy’, which connotes a reduction of the economy-wide energy intensity by following a heterogeneous taxation policy across sectors.     

Optimal monetary policy under incomplete markets and aggregate uncertainty: A long-run perspective

This paper examines the role of monetary policy in an environment with aggregate risk and incomplete markets. In a two-period overlapping-generations model with aggregate uncertainty, optimal monetary policy attains the ex-ante Pareto optimal allocation. This policy aims to stabilize the savings rate in the economy by changing real returns of nominal bonds via variation in expected inflation. Optimal expected inflation is procylical and on average higher than without uncertainty. Simple inflation targeting rules closely approximate the optimal monetary policy.     

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.     

Monetary policy and learning from the central bank's forecast

We examine the expectational stability (E-stability) of rational expectations equilibrium (REE) in a standard New Keynesian model in which private agents refer to the central bank's forecast in the process of adaptive learning. To satisfy the E-stability condition in this environment, the central bank must respond more strongly to the expected inflation rate than the extent to which the Taylor principle suggests. However, the central bank's strong reaction to the expected inflation rate raises the possibility of indeterminacy of the REE. In considering these problems, a robust policy requires responding to the current inflation rate to a certain degree.     

Optimal fiscal and monetary policy with occasionally binding zero bound constraints

This paper studies optimal fiscal and monetary policy when the nominal interest rate is subject to the zero lower bound (ZLB) constraint in a stochastic New Keynesian economy. In the baseline model calibrated to match key features of the U.S. economy, it is optimal for the government to increase its spending when at the ZLB in the stochastic environment by about 60 percent more than it would in the deterministic environment. The presence of uncertainty creates a unique time-consistency problem if the steady state is inefficient. Although access to government spending policy increases welfare in the face of a large deflationary shock, it decreases welfare during normal times as the government reduces the nominal interest rate less aggressively before reaching the ZLB.     

The impact of credit and fiscal policy under a liquidity trap

This study examines the interaction of non-conventional credit policy and fiscal policy when adverse financial conditions drive the economy to a deep contraction and conventional monetary policy becomes ineffective as the policy interest rate reaches its effective lower bound. Consistent with other studies, under counter-cyclical financial intermediation costs, credit easing policies aimed at reducing credit spread ameliorate the response of the economy and lead to a faster recovery. More importantly, I find that expansionary fiscal policy during an episode of liquidity trap is associated with a large multiplier effect that prevents an otherwise deeper and longer recession. Moreover, the large impact of expansionary fiscal policy is maintained even if credit policy is already in place.     

Determinants of discretionary fiscal policy in Central and Eastern Europe

This paper explores economic, political and institutional determinants of discretionary fiscal policy in 11 Central and Eastern European (CEE) countries from 2000 to 2013 and compares discretionary fiscal reactions before and during the global economic crisis. We find that fiscal policy was procyclical to the output gap both before and during the crisis, while no fiscal reaction to the absorption gap was captured. Our results also indicate a negative relationship between the level of public debt and deficits over the entire period and the pre-crisis period, suggesting that rising public debt represented a brake on future deficits. We also find that election cycles affect the fiscal deficit, but only during the pre-crisis period, while no evidence of a relationship between fiscal policy and government fragmentation was captured. We find some evidence that in the pre-crisis period the CEE countries with a fixed exchange rate regime ran lower deficits than those with a floating regime, whereas during the crisis no impact of the exchange rate regime on the fiscal deficit was found. There is also some evidence that an arrangement with the IMF was associated with lower deficits for the entire sample period. However, no impact of EU accession on the fiscal stance was identified.     

Optimal fiscal policy with robust control

This paper analyzes how consumer uncertainty affects optimal fiscal policy in the Lucas and Stokey (1983) framework. The consumers, lacking confidence in their knowledge of the stochastic environment, endogenously tilt their subjective probability model away from an approximating probability model. The government, though, is confident that the approximating probability model characterizes the stochastic environment. This confidence dichotomy reveals a range of possible objective functions for an altruistic government. I assume that the government maximizes the consumers' expected utility under the consumers' own subjective probability model. It is found that this government relies less heavily on labor taxes to absorb the fiscal shock than would be optimal if consumers were fully confident in their probability model. This policy helps mitigate the direct welfare cost associated with consumer uncertainty. I compare this policy to the one implemented by a government that maximizes the consumers' expected utility under the approximating probability model.     

Equilibria under monetary and fiscal policy interactions in a portfolio choice model

This paper studies how the presence of income-taxes changes the properties of general equilibrium models with monetary and fiscal policy interactions. It is found that from a global perspective, the only policy regime that leads to a unique equilibrium is one where fiscal policy is active, i.e. the fiscal theory of the price level regime in Sims (1994). From a local perspective, there are three regimes. In particular, and relative to the previous literature following Leeper (1991), a new third regime exists where a passive fiscal rule combined with a passive monetary rule can still deliver determinacy where the same area of the parameter space would lead to multiple solutions if taxes were lump sum. To obtain the size of the new regime, the paper characterizes analytically the extent to which tax cuts are self-financing and how the distortionary tax Laffer curve looks near the steady state. In the new regime, monetary and fiscal backstops are brought into play so as to rule out off equilibrium dynamics, and inflation can temporarily increase in order to increase seigniorage revenues. With this flexibility, the monetary policy is consistent with the real debt remaining bounded, and the arithmetic that follows is monetarist and unpleasant in the sense of Sargent and Wallace (1981).     

Optimal policy in Markov-switching rational expectations models

In this paper we consider the optimal quadratic control problem of Markov-switching linear rational expectation models. These models are general and flexible tools for modelling not only regime but also model or parameter uncertainty. We show, first, how to find the solution of a Markov-switching linear rational expectation model. Based on this solution we then show how to apply dynamic programming to find the optimal time-consistent policy and the resulting Nash-Stackelberg equilibrium. Suitable modifications of the algorithm allow to deal with the (non-RE) case in which the policymaker and the private sector hold different beliefs or probabilities over regime change. We also show how the optimisation procedure can be employed to obtain the optimal policy under commitment. As an illustration we compute the optimal policy in a small open economy subject to stochastic structural breaks in some of its key parameters.     

Optimal monetary policy rules,financial amplification,and uncertain business cycles

This paper studies optimal monetary policy in the presence of ‘uncertainty’, time-variation in cross-sectional dispersion of firms׳ productive performance. Using a model with financial market imperfections, the results suggest that (i) optimal policy is to dampen the strength of financial amplification by responding to uncertainty (at the expense of creating mild degree of fluctuations in inflation). (ii) Higher uncertainty makes the welfare-maximizing planner more willing to relax financial constraints. (iii) Credit spreads are a good proxy for uncertainty. Hence, a non-negligible response to credit spreads – together with a strong anti-inflationary policy stance – achieves the highest aggregate welfare possible.     

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.     

Learning about fiscal policy and the effects of policy uncertainty

In this paper we ask how uncertainty about fiscal policy affects the impact of fiscal policy changes on the economy when the government tries to counteract a deep recession. The agents in our model are uncertain about the conduct of fiscal policy and act as econometricians by estimating fiscal policy rules that might change over time.We find that assuming that agents are not instantaneously aware of the new fiscal policy regime in place leads to substantially more volatility in the short run and persistent differences in average outcomes. We highlight issues that can arise when a policymaker wants to announce a policy change. From a methodological perspective, we introduce a novel way to model learning in the face of discrete policy changes.     

The impact of performance-based budgeting on state fiscal performance

Almost all American States have tried some form of performance-based budgeting, and this study examines the impact of this budget process innovation on state expenditures. Using panel data for 1970 through 1997 the findings indicate that performance-based budgeting curtails state spending per capita by at least two percentage points. However, not all state government programs are affected equally; some budget categories experience spending increases after the implementation of performance budgeting. The paper also examines the adoption pattern among states of performance budgeting rules.Submittied: May 2002, Accepted: December 2002, JEL Classification Numbers: H3, H7, H72We are grateful to Ami Glazer, Tim Muris, Gordon Tullock, and to two anonymous referees for valuable comments on an earlier draft, and to the Center for Study of Public Choice for financial support. We are responsible for remaining errors.     

Anticipation,learning and welfare: the case of distortionary taxation

We study the impact of anticipated fiscal policy changes in a Ramsey economy where agents form long-horizon expectations using adaptive learning. We extend the existing framework by introducing distortionary taxes as well as elastic labor supply, which makes agents’ decisions non-predetermined but more realistic. We detect that the dynamic responses to anticipated tax changes under learning have oscillatory behavior that can be interpreted as self-fulfilling waves of optimism and pessimism emerging from systematic forecast errors. Moreover, we demonstrate that these waves can have important implications for the welfare consequences of fiscal reforms.     

Optimal monetary policy in a new Keynesian model with animal spirits and financial markets

This article presents a macro-finance-interaction model that integrates a NKM with bounded rationality and an agent-based financial market model. We derive four interactive channels between the two sectors where two channels are strictly microfounded. We analyze the impact of the different channels on economic stability and derive optimal (conventional and unconventional) monetary policy rules. We find that coefficients of optimal Taylor rules do not significantly change if financial market stabilization becomes part of the central bank׳s objective function. Additionally, we show that rule-based, backward-looking monetary policy creates huge instabilities if expectations are boundedly rational. Our model is externally validated by showing that it generates fat tailed output growth rates.     

Measuring the effects of fiscal policy

Measuring the effects of discretionary fiscal policy is both difficult and controversial, as some explicit or implicit identifying assumptions need to be made to isolate exogenous and unanticipated changes in taxes and government spending. Studies based on structural vector autoregressions typically achieve identification by restricting the contemporaneous interaction of fiscal and non-fiscal variables in a rather arbitrary way. In this paper, we relax those restrictions and identify fiscal policy shocks by exploiting the conditional heteroscedasticity of the structural disturbances. We use this methodology to evaluate the macroeconomic effects of fiscal policy shocks in the U.S. before and after 1979. Our results show substantive differences in the economy׳s response to government spending and tax shocks across the two periods. Importantly, we find that increases in public spending are, in general, more effective than tax cuts in stimulating economic activity. A key contribution of this study is to provide a formal test of the identifying restrictions commonly used in the literature.     

Optimal fiscal policy for a state or local government

State and local government services are enjoyed by, and taxes borne by, two groups, residents and non-residents. This paper addresses the question: if state and local governments maximize their residents' welfare, and cannot distinguish between individual residents and non-residents but know the aggregate characteristics of the two groups, what set of taxes (subsidies) and public goods should they choose? Some of the results obtained are: (i) even when all commodities are taxable and equity is ignored, the existence of non-resident consumption makes uniform taxation non-optimal; (ii) in some cases, whether a commodity should be taxed or subsidized is independent of its own-price elasticity; (iii) central cities may be subsidized by suburban residents; and (iv) the ability of state and local governments to redistribute is inversely proportional to the openness of the economy.     

Implications of productive government spending for fiscal policy

The standard assumption in macroeconomics that government spending is unproductive can have substantive implications for tax and spending policy. Productive government spending introduces a positive feedback between the tax rate, the productive capacity of the economy, and tax revenue. We allow marginal tax revenue to be optimally allocated between productive subsidies to human capital and utility-enhancing government consumption and calculate Laffer Curves for the US. Productive government spending yields higher revenue-maximizing tax rates, steeper slopes at low tax rates and higher peaks. The differences are particularly pronounced for the labor-tax Laffer curve. The use of tax revenue is an important determinant of the actual revenue that a tax rate increase generates.