Stable and enforceable: a new fiscal framework for the Euro area

Since the great financial crash, the need for new fiscal rules to prevent unsustainable fiscal policies is universally recognised. In practice such rules, including those in the Stability and Growth Pact, have proved to be impossible to enforce. Thus, to avoid unsustainable fiscal policies reappearing, and to prevent monetary policy from being undermined by undisciplined governments, there is a need for a framework capable of imposing fiscal discipline. This paper considers an intertemporal assignment, where fiscal policy focuses on long-term objectives and monetary policy on short-term stabilisation. We argue for public sector debt targets as a practical way to achieve such a set up, and an excess debt protocol is constructed to give enforceable form to those targets. The ideas of “fiscal space” and optimal debt levels are used to provide a mechanism for identifying a stable region within which the debt targeting regime should operate. Making these factors explicit would both improve the credibility of planned fiscal policies and reduce risk premia on borrowing costs. We finally show how Europe’s competitiveness pact, and debt restructuring operations, can be used to maximise the available fiscal space.     

Mix of Fiscal and Monetary Policy Rules and Inflation Dynamics in China

The present paper examines the role of the mix of fiscal and monetary policy rules in determining inflation dynamics using fiscal and monetary policy reaction functions and Markov‐switching vector autoregression methods based on quarterly data in the period 1992–2007. Our results show that fiscal and monetary policies in China can be adequately described using some simple rules, and that significant regime shifts took place around 1998. Fiscal policy tended to be active and countercyclical in the pre‐1998 period, then switched to be passive and more countercyclical, whereas monetary policy was characterized as passive and procyclical in the pre‐1998 period, and switched to be active and countercyclical afterwards. The mix of fiscal and monetary policy rules can explain inflation dynamics better than the monetary policy rule alone. Therefore, price stability requires not only appropriate monetary policy but also appropriate fiscal policy.     

THE CYCLICALITY OF MONETARY AND FISCAL POLICY IN SOUTH AFRICA SINCE 1994

This paper uses a structural vector‐autoregression approach to discuss the cyclicality of fiscal and monetary policy in South Africa since 1994. There is substantial South African literature on this topic, but much disagreement remains. Though not undisputed, there is growing consensus that monetary policy has contributed to the remarkable stabilisation of the South African economy over this period. The evaluation of the role of fiscal policy in stabilisation has been less favourable and there is little evidence that a countercyclical fiscal stance was a priority over this period. This paper considers these issues in an empirical framework that addresses some of the shortcomings in the literature. Specifically, it constructs a structural model in contrast with the reduced form models typically used in the South African literature, incorporates the dynamic interaction between monetary and fiscal shocks on the demand side and supply shocks on the other, and avoids controversy over “neutral” base years and the size of fiscal elasticities. The model confirms the consensus on monetary policy, finding it to have been largely countercyclical since 1994. On fiscal policy, this paper finds evidence of pro‐cyclicality, especially in the more recent period, though the policy simulations suggest that the pro‐cyclicality of fiscal policy has had little destabilising impact on real output.     

中国货币政策的福利损失与政策规则选择——基于新凯恩斯DSGE模型的分析

本文在新凯恩斯主义DSGE模型框架下,运用福利损失函数和脉冲响应方法研究我国最优货币政策规则选择的问题。研究结果表明,货币供应量规则相对于利率规则,使外生冲击对产出和通货膨胀的影响更持久,造成更大的福利损失,因此中央银行的货币政策规则应该逐步从货币供应量规则转向利率规则;在一定条件下,前瞻型利率规则、后顾型利率规则和泰勒规则所造成的福利损失相差不大,从便利的角度出发,中央银行应该选择后顾型利率规则。     

Automatic Fiscal Stabilisers: What They Are and What They Do

The global financial and economic crisis has revived the debate in the academic literature and in policy circles about the size and effectiveness of automatic fiscal stabilisers. Especially in the euro area where monetary policy is centralised and discretionary fiscal policy making is constrained by the EU fiscal rules, knowing the size and the effectiveness of automatic stabilisers is crucial. While automatic stabilisers are a fairly established concept in the fiscal policy literature, there is still no consensus about their actual nature and their effectiveness. This paper shows that differences in opinion mirror a deeper disagreement over how the budget would look like without automatic stabilisers. This issue is addressed by defining two types of counterfactual budgets giving rise to two different interpretations about the nature of automatic stabilisation. Simulations with a structural model confirm that the degree of smoothing is conditional on how the counterfactual budget, i.e. the budget without automatic stabilisers, is defined.     

Accession to the euro-area: a stylized analysis using a NK model

This paper analyses the accession to the euro-area by new members using a stylized new-Keynesian model. We analyze macroeconomic adjustment in the pre- and post-accession case and calculate welfare in both situations to obtain net benefit/loss from accession. It is shown how the effects of accession is related to the conduct of monetary policy and fiscal policy in the pre- and post-accession case. The simulation examples point at the potential costs that accession might entail due its consequences on monetary and fiscal policy design. These consequences from accession in terms of macroeconomic stabilization ability of monetary and fiscal policies have not always been fully acknowledged and may need more attention.     

Budgetary-Neutral Fiscal Policy Rules and External Adjustment

Large external imbalances and fragile fiscal positions have emerged as major policy challenges for the euro area in the financial crisis. The paper analyses whether shifting government purchases between tradable and non-tradable goods could help reduce external fluctuations without large swings in the overall fiscal stance. The policy rules considered are budgetary-neutral in the sense that the overall level of government expenditure is kept constant. We compare the policy rules to fiscal devaluation as a strategy to reduce external imbalances and find that state-dependent changes in the composition of government purchases between tradables and non-tradables can stabilise excessive fluctuations in the event of economy-wide supply and demand shocks. Contrary to fiscal devaluation, the expenditure-shifting rule faces a trade-off between stabilising domestic activity and enhancing household welfare, on the one hand, and reducing excessive fluctuations in external positions, on the other hand. The excess volatility of domestic variables associated less volatility in the external position implies welfare losses for standard specifications of household utility. The adverse welfare effect is absent in the case of fiscal devaluation.     

How successful has stabilization policy been in The Netherlands? A neo-Keynesian perspective

Summary A modern Keynesian perspective is offered on the conduct of monetary, fiscal and exchange rate policy in the Netherlands during the period 1960-1976. A small open macroeconomic model is estimated and simulated under alternative policy rules. Striking features are a strong real balance effect on consumer spending and a significant contribution of exchange rate changes to domestic inflation. Actual policy performs no better as regards the achievement of internal and external balance than simple fixed rules. Both actual policy and fixed rules are dominated by instrument values derived from an explicit optimal stabilization approach. We would like to express our thanks to Bill and Ken Rosen for helpful discussions on estimation and stimulation techniques and to S. Kuipers and H. Verwilst for help in obtaining data. Peter Kenen and S. Kuipers offered detailed comments on an earlier draft.     

Learning the fiscal theory of the price level: Some consequences of debt-management policy

This paper examines the consequences of the scale and composition of the public debt in policy regimes in which monetary policy is ‘passive’ and fiscal policy ‘active’. This configuration of policy is argued to be of both historical and contemporary interest, in economies such as the US and Japan. It is shown that higher average levels and moderate average maturities of debt can induce macroeconomic instability for a range of policies specified as simple rules. However, interest-rate pegs combined with active fiscal policies almost always ensure macroeconomic stability. This suggests that in periods where the zero lower bound on nominal interest rates is a relevant constraint on policy design, a switch in fiscal regime is desirable.     

Effectiveness of history-dependent monetary policy

In this paper, we evaluate the effectiveness of history-dependent monetary policy, focusing on the design of targeting regimes and simple policy rules. Our quantitative analysis is based on a small estimated forward-looking model of the Japanese economy with a hybrid Phillips curve. Our main findings are: (1) History-dependent targeting regimes, such as price level targeting and income growth targeting, outperform inflation targeting; (2) Committing to a simple history-dependent policy rule results in nearly the same social welfare as the optimal delegation of price level targeting and income growth targeting; (3) The central bank can achieve almost the same performance as the optimal commitment policy by adopting the first difference hybrid policy rule in which the change in interest rate responds to inflation, output gap, and real income growth rate. J. Japanese Int. Economies 18 (3) (2004) 330–361.     

Macroeconomic stabilization through monetary and fiscal policy coordination: Implications for European Monetary Union

In a two-country model, we consider the implications of monetary and fiscal policy coordination for macroeconomic stabilization. We show that the optimal regime is one of monetary and fiscal policy coordination under flexible exchange rates. In the context of the European Community, this suggests that the desire to fix exchange rates may not be costless. In addition, we show that fiscal coordination requires a relatively high degree of flexibility in fiscal policy. This result suggests that limits on the flexibility of fiscal policies, as suggested in the Delors Report, may hinder macroeconomic stabilization.     

EMU Stability: Direct and Indirect Risk Sharing

Our paper aims to analyze the effectiveness of different risk-sharing mechanisms in providing stability to a monetary union. We select two stylized tools with extreme and opposite features. The first is an expansionary but conventional monetary policy that is used to help EMU’s most fragile member states manage their public debts; the second is a centralized fiscal policy that allows for the transfer of a portion of these public debts from EMU’s most fragile member states to those considered EMU’s “core”. By a stylized periphery-core model of a monetary union, we compare the strengths and weaknesses of these two tools in order to reach some welfare implications in terms of union stability.     

Alternative views of the money transmission mechanism: what difference do they make for monetary policy?

This paper examines how alternative views of the monetary transmissionmechanism affect the choice of a monetary policy rule. The mainfinding is that many different structural models indicate thatthe same simple monetary policy rule - one in which the centralbank's target short-term interest rate reacts to inflation andto real output - would perform well. Such rules work well evenin models where the monetary transmission mechanism has a relativelystrong exchange-rate channel. The models differ, however, intheir implications for more complex monetary rules.     

Stability and Growth Pact: issues and lessons from political economy

The paper analyses the EU fiscal rules from a political economy perspective and derives some policy lessons. Following a literature survey, the paper stresses the importance of appropriate incentives for rule compliance in an environment where national fiscal sovereignty precludes the option of centralised enforcement. In addition, the paper stresses the importance of clear and simple rules and in particular the 3% deficit limit in anchoring expectations of fiscal discipline and facilitating public and market monitoring of public finances. This, in turn, strengthens incentive for rule compliance. Moreover, the paper discusses the interests of the most important players in European fiscal rule formation and the importance of choosing the appropriate time for initiating a reform debate.Non-technical summary The EU fiscal framework as laid down in the Maastricht Treaty and the Stability and Growth Pact (SGP, the Pact) aims to preserve fiscal sustainability while allowing room for automatic fiscal stabilisation. These two objectives are also at the heart of the ECB’s interest in the EU fiscal framework because their attainment facilitates monetary policy making in the short and long run.The paper analyses the EU fiscal rules from a political economy perspective and derives some policy lessons. The literature review of the first part reveals that fiscal rules can help solve deficit/debt biases and time inconsistency problems by constraining the behavior of policy makers. But rules can also mitigate biases if they facilitate financial market and public scrutiny of fiscal policies.Thereafter, the paper analyses the institutional environment in which EU fiscal rules are applied. It argues that EU rules reflect a “contract” amongst countries that retain sovereignty on fiscal policies. Enforcement, therefore, ultimately has to be undertaken by the contracting parties. Due to this constraint, the rules can also be characterised as “soft” law (with the 3% limit being nevertheless a much “harder” constraint than the other elements). But this does not necessarily imply that the rules are ineffective (or “dead”). Soft law reduces political transaction costs (by improving transparency and providing a forum for peer pressure). Moreover, if well-designed, such law can boost incentives towards making the rules “self-enforcing”. Evidence speaks in favour of this view: while EU fiscal rules were bent in a number of cases and compliance is undeniably of concern, major and rapid fiscal balance deteriorations have been largely prevented since the start of EMU.The paper also looks at potential trade-offs between “complex” rules where a “fine-tuned” economic rationale may boost acceptance of the rules versus simple and clear rules that allow easy monitoring. It is argued that clarity and simplicity of rules are important especially when formal enforcement is limited (“soft law”) and public monitoring becomes more important. By facilitating public and market monitoring of compliance, clear and simple rules are also more costly to breach.The benefits of “complexity”, and in particular the use of administrative discretion to fine tune the rules to country situations have limits, in particular when it comes to the excessive deficit procedure (EDP). It is argued that the 3% deficit limit and the time frame for correcting excessive deficits already provide some room to accommodate economic circumstances. The 3% limit must be clear, simple and strictly implemented to anchor expectations of fiscal discipline and to facilitate public and market monitoring. Further discretion and relaxation would conflict with this need. From this angle, other risks (e.g., efforts not materializing, structural reforms producing surprise costs etc) are hard to justify as a reason for extending deadlines to correct excessive deficits.The preventive arm of the Pact with its requirement of close-to-balance-or-in-surplus budgetary positions defines sound medium term budget positions and adjustment paths. This may be appropriately fine-tuned to address concerns about the Pact’s underlying economic rationale. For example, a symmetric application in good and bad times and less time inconsistency would be desirable.Finally, the timing of a debate on fiscal rules needs to be carefully chosen. In the EU context (and perhaps in other contexts as well), there seems to be much inherent pressure to make the rules more “complex”. Moreover, for the debate initiated in summer 2004, there was also no willingness by countries to give up sovereignty nor was there a sense of urgency to strengthen public finances via tighter rule implementation and enforcement. In such an environment, it is likely that changes to fiscal rules make them more complicated, discretionary and, thereby, potentially less enforceable.The views expressed are those of the author and not of the ECB. Comments by Vitor Gaspar, Mark Hallerberg, Steven Keuning, Jose Marin, Richard Morris, Gilles Noblet, Hedwig Ongena, Luca Onorante, Rolf Strauch, Juergen von Hagen, an anonymous referee and valuable assistance by Anna Foden are much appreciated.     

Vehicle currency pricing and its positive welfare consequences under optimal monetary policy

Using a two-country general equilibrium model, this paper analytically derives the possibility of positive welfare consequences of vehicle currency use in invoicing international trades. Such vehicle currency use is prominent in the data. The literature points out welfare loss under optimal monetary policy due to vehicle currency pricing relative to the flexible price equilibrium outcome, modeling only tradable goods. By introducing nontradable goods and their sector-specific productivity shocks, this paper provides a closed-form condition under which one country's welfare is higher under optimal monetary policy if its exports are invoiced with the other country's currency than if invoiced with its own currency, given that the other country's exports are invoiced with the producer's currency. That is, this paper derives a condition under which vehicle currency pricing is preferred by the nonvehicle currency country to producer currency pricing.     

Rules,discretion, and international monetary and fiscal policy coordination

This paper considers the implications of international policy coordination when both monetary and fiscal policy choices are endogenous. We show that a movement from insular monetary commitment to international monetary policy coordination will, if fiscal policies are not coordinated, produce higher output and public expenditure levels at the expense of higher inflation rates. We also show that the concurrent coordination of monetary and fiscal policies raises output and inflation while lowering public expenditure relative to a regime of monetary coordination alone. We conclude that the arguments for concurrent monetary and fiscal policy coordination fail to have a clear-cut theoretical basis.     

贸易摩擦背景下关税与货币政策反制策略研究

通过将贸易品美元定价约束、外汇噪声交易和关税反制等特征融入两国DSGE模型,文章对贸易摩擦背景下美国进口关税冲击的传导渠道以及中国的关税反制策略与货币应对政策有效性等问题进行了数值分析。研究发现,关税反制措施能够有效地对冲美国加征进口关税对中国实际产出、消费和净出口的消极影响,并有助于抑制人民币实际汇率贬值。若进一步搭配将出口品关税纳入利率调控框架的积极货币政策,对于经济扩张与保持汇率稳定都更加有效。但从长期社会福利角度看,积极货币政策对美国经济也具有明显的正向溢出作用,关税反制则会产生显著的福利转移效应,不采取任何关税与货币应对政策将使中国遭受最大的福利损失。因此,基于"打击最大化、自损最小化"原则,中国应对美国采取坚决有力的关税反击,同时保持货币政策相对中性、克制,以期实现"以战促和"的战略目标。     

Testing policy effectiveness during COVID-19: An NK-DSGE analysis

We examine the effectiveness of fiscal and monetary policy in mitigating the impact of COVID-19 in India using the NK-DSGE framework. In terms of policy effectiveness, our findings imply that expansionary monetary policy is effective in reviving economic growth both from the demand side and supply side. In contrast, expansionary fiscal policy is effective only from the supply side. Our findings recommend the implementation of optimal policy mix in a coordinated and staggered framework for effective mitigation of ill-effects of the COVID-19, such as reviving employment and capacity utilization to its pre-pandemic level with minimal inflationary effects.     

Fiscal Deficits, Taylor Rules, and Price Dynamics

This paper reconsiders the issue of price level determination under interest rate feedback rules using an optimizing general equilibrium framework with overlapping generations and flexible prices. The analysis shows that under fiscal shocks, monetary policy commitment to instrument rules of the Taylor-type might be insufficient for inflation control. It is also demonstrated that the existence of a unique stable equilibrium path for the price level does not require active monetary rules.The author wishes to thank an anonymous referee, Barbara Annicchiarico, Giuseppe De Arcangelis, Giancarlo Marini, and Giorgio Rodano for useful comments and suggestions.The usual disclaimer applies.