Rational expectations,the government budget constraint,and the optimal money supply

A stylized macroeconomic model incorporating a surprise supply function is examined. Extension of the model to recognize the government budget constraint makes it clear that random elements must enter into the determination of some policy variable in the face of exogenous shocks elsewhere in the model. Allowing these random elements to enter into the money supply may be a useful automatic countercyclical policy contrary to the usual inference that a deterministic money supply policy will be better.     

The government budget constraint with endogenous money

This paper examines the effectiveness and stability of fiscal policy in a model with a budget constraint and an endogenous money stock. This model avoids the need to treat only two polar cases, pure bond and pure money financing-neither of which is appropriate given the structure of the monetary system and the way monetary policy has been conducted historically. Furthermore, the model allows one to differentiate the effects of a money-financed deficit for the different tools of monetary control. We find that neither the long-run effectiveness nor stability of a mixed bond/money financed deficit is invariant to the monetary policy tool used.     

Are government bonds net wealth? intertemporal optimization and the government budget constraint

Full integration of the government sector's intertemporal budget constraint into the private sector's intertemporal budget constraint implies the Ricardian equivalence proposition associated with Barro (1974) is valid. Private sector holdings of government bonds are not net wealth. Previous tests of the equivalence proposition estimate Keynesian consumption relationships augmented by alternative measures of government liabilities. Decisive results have not been obtained. The test presented here uses a formulation of the permanent income model to test the integration of the government's intertemporal budget constraint into the private sector's intertemporal budget constraint. The explicit use of a forward looking model of consumption imposes constraints on the equation estimated and on construction of the data; the present test is a significant improvement. The results of this test do not support the equivalence proposition.     

Debt financing,soft budget constraints,and government ownershipEvidence from China1

Debt financing is expected to improve the quality of corporate governance, but we find, using a large sample of public listed companies (PLCs) from China, that an increase in bank loans increases the size of managerial perks and free cash flows and decreases corporate efficiency. We find that bank lending facilitates managerial exploitation of corporate wealth in government‐controlled firms, but constrains managerial agency costs in firms controlled by private owners. We argue that the failure of corporate governance may derive from the shared government ownership of lenders and borrowers, which nurtures soft budget constraints.     

The effects of alternative fiscal policies on the intertemporal government budget constraint

This article presents the effects of alternative fiscal policies on the intertemporal government budget constraint when the time horizon of the policy maker varies. I show that the wealth effect associated with cuts in the skill-adjusted labor income tax rate improves the intertemporal budget balance, whereas the intertemporal substitution effect associated with the physical capital income tax rate deteriorates the intertemporal budget. Under plausible parameter values, the tax rate on skill-adjusted labor income cannot by itself balance the intertemporal budget at all horizons.     

Dynamic monetary and fiscal policy and the government budget constraint: A growth equilibrium

This paper investigates a dynamic macroeconomic model with the government-budget constraint. The model deviates from many previous studies by assuming that long-run equilibrium is characterized by all stock variables growing at rates which imply an unchanging interest rate. Of the two solutions, one is the standard constant-assetstock equilibrium while the other is either a positive- or a negative-growth equilibrium. One of the solutions is always locally stable while the other is locally unstable. Consequently, when the constant-asset-stock equilibrium is unstable (stable) the positive-(negative-) growth equilibrium is stable (unstable).     

The estimation of British local government expenditure decisions under a piecewise linear budget constraint

In the light of the reforms that have affected local government finance in Britain, the empirical analysis of local government responses to the changes in the grant system has become a topical subject because of its policy implications. Barnett et al.proposed different models to predict the likely impact of the reforms on local government expenditure but never tested ofr the validity of the functional form used in their model. The main reason for this omission is related to the piecewise nature of the budget constraint faced by local authorities which complicated the estimation techniques and restricted the choice of the functional forms that could be used. The presented here tests for the validity of the functional form using data for the three fiscal years that preceded the poll tax reform, namely 1986–87 to 1988–89 and suggests specific tests to compare the parameters obtained using different models. The main conclusion of the analysis is that only the behaviour of metropolitan districts is consistent with utility maximization.     

Trade liberalization, heterogeneous firms and the soft budget constraint

We analyze the interaction between the soft budget constraint (SBC) and international trade by placing Segal’s (1998) SBC model within Melitz’s (2003) framework of international trade with heterogeneous monopolistically competitive firms. As in Segal’s model, SBC may result in moral hazard. The opening to international trade adds another sort of inefficiency. Some firms that would have become exporters in the absence of SBC choose to apply low effort and not export in order to extract a subsidy from the government. This effect takes place when the trade costs are sufficiently low. Overall, however, trade liberalization reduces inefficiencies generated by SBC. The number of firms subject to moral hazard SBC decreases, aggregate effort level increases and aggregate profits lost due to SBC-induced sub-optimal effort decline as trade costs decrease.     

Investment decisions and the soft budget constraint

This paper investigates the investment behaviour of a large panel of Hungarian firms in the period 1989–99, in order to assess the impact of institutional and regulatory changes on the efficiency of credit allocation. We find that the role of financial factors for investment decisions has changed significantly after the introduction of major financial reforms, and that firms were affected differently depending on their ownership type. Reforms have hardened the budget constraint of private domestic firms, particularly small ones, and reduced informational problems for foreign‐owned firms. State‐owned firms remained subject to a soft budget constraint. In particular, small state firms became more sensitive to financial conditions, whereas large state firms were unaffected and kept operating under a soft budget constraint.     

Investment and the soft budget constraint in China

This paper examines the incentive effects of the soft budget constraint on the investment behavior of firms in general and on the investment-cash flow sensitivity in particular. To this end, we develop a simple model of moral hazard that takes the soft budget constraint into account. Within this moral hazard environment, we show that investment is positively related to the amount of internal funds. We further show that the presence of the soft budget constraint deteriorates the moral hazard problem, thereby making the investment level less sensitive to the amount of internal funds. This is the case irrespective of whether the soft budget constraint renders the firm more or less liquidity constrained. To test the model's empirical implications, we employ data of China's listed companies for the period from 1997 to 2003. We use the share of state ownership as a proxy for the severity of the soft budget constraint. We find strong evidence that firms with larger shares of state ownership exhibit lower investment-cash flow sensitivities than firms with smaller shares of state ownership.     

The Korean financial crisis and the soft budget constraint

A panel of Korean firms is used to test for the soft budget constraint (SBC) in bank lending before and after the 1997–1998 financial crisis. SBC is present if a firm can borrow from its bank despite being in financial distress, which we define by a low Altman's z-score. We find that prior to 1997 financially distressed firms were able to borrow while after the crisis their ability to borrow declined substantially. We also demonstrate that SBC was a significant factor in the firms’ propensity to default during the crisis.     

A political economy theory of the soft budget constraint

Why do soft budget constraints exist and persist? In this paper we argue that the prevalence of soft budget constraints can be best explained by the political desirability of softness. We develop an infinite horizon political economy model where neither democratic nor autocratic politicians can commit to policies that are not ex post optimal. We show that because of the dynamic commitment problem inherent in the soft budget constraint, politicians can in essence commit to make transfers to entrepreneurs which otherwise they would not be able to do. This encourages such entrepreneurs to support them politically. Though the soft budget constraint may induce economic inefficiency, it may be politically rational because it influences the probability of political survival. In consequence, even when information is complete, politicians may fund bad projects which they anticipate they will have to bail out in the future. We show that, maybe somewhat surprisingly, dictators who are less likely to lose power, are more likely to use the soft budget constraint as a strategy to gain political support.     

Using the budget constraint to monetarise impact assessment results

Recent developments in Life Cycle Impact Assessment (LCIA) provide a basis for reducing the uncertainty in monetarisation of environmental impacts. The LCIA method “Ecoindicator99” provides impact pathways ending in a physical score for each of the three safeguard subjects humans, ecosystems, and resources. We redefine these damage categories so that they can be measured in terms of Quality Adjusted Life Years (QALYs) for impacts on human well-being, Biodiversity Adjusted Hectare Years (BAHYs) for impacts on ecosystems, and monetary units for impacts on resource productivity.The monetary value of a QALY can be derived from the budget constraint, i.e. the fact that the average annual income is the maximum that an average person can pay for an additional life year. Since a QALY by definition is a life-year lived at full well-being, the budget constraint can be determined as the potential annual economic production per capita at full well-being. We determine this to be 74,000 EUR with an uncertainty estimate of 62,000 to 84,000 EUR. This corresponds well to the 74,627 EUR willingness-to-pay estimate of the ExternE project. Differences to other estimates can be explained by inherent biases in the valuation approaches used to derive these estimates.The value of ecosystems can be expressed in monetary terms or in terms of QALYs, as the share of our well-being that we are willing to sacrifice to protect the ecosystems. While this trade-off should preferably be done by choice modelling, only one such study was found at the level of abstraction that allows us to relate BAHYs to QALYs or monetary units. Stressing the necessity for such studies, we resort to suggest a temporary proxy value of 1400 EUR/BAHY (or 52 BAHY/QALY), with an uncertainty range of 350 to 3500 EUR/BAHY.The practical consequences of the above-described monetarisation values has been investigated by combining them with the midpoint impact categories of two recent LCIA methods, thus providing a new LCIA method with the option of expressing results in both midpoints and an optional choice between QALY and monetary units as endpoint. From our application of the new method to different case studies, it is noteworthy that resource impacts obtain less emphasis than in previous LCIA methods, while impacts on ecosystems obtain more importance. This shows the significance of being able to express impacts on resources and ecosystems in the same units as impacts on human well-being.     

Optimal composition of government public capital financing

Most recent studies on growth models with public investment in infrastructure (public capital) presume that public capital is financed by income taxation. However, in the model where money is demanded for transactions, this paper finds that optimal public capital financing in general involves utilizing both income taxation and seigniorage. In such a case, the optimal income tax rate is less than the output elasticity of public capital, a reasonable result compared with empirical evidence.     

Soft budget constraint theories: From centralization to the market

This paper surveys the theoretical literature on the effect of soft budget constraints on economies in transition from centralization to capitalism; it also reviews our understanding of soft budget constraints in general. It focuses on the conception of the soft budget constraint syndrome as a commitment problem. We show that the two features of soft budget constraints in centralized economies – ex post renegotiation of firms' financial plans and a close administrative relationship between firms and the centre – are intrinsically related. We examine a series of theories (based on the commitment-problem approach) that explain shortage, lack of innovation in centralized economies, devolution, and banking reform in transition economies. Moreover, we argue that soft budget constraints also have an influence on major issues in economics, such as the determination of the boundaries and capital structure of a firm. Finally, we show that soft budget constraints theory sheds light on financial crises and economic growth.     

Cash-flow news,market liquidity and liquidity risk

This article adopts Campbell's (1991) return decomposition model to decompose the unexpected stock return and unexpected excess stock return in the US stock market. The study also investigates the factors that cause the shock to stock return and excess stock return. We further examine the responses of stock market to cash-flow news, expected stock return news, expected excess stock return news and interest rate news. Last, we examine the reaction of market liquidity, liquidity risk and abnormal trading volume to cash-flow news, expected stock return news, expected excess stock return news and interest rate news. Our main findings are summarized as follows: first, cash-flow news is the main driver of stock return and excess stock return in stock market. Second, the dividend payout ratio is able to predict stock return and excess stock return. Third, under the model of stock return variance, unexpected market liquidity and unexpected liquidity risk are negatively related to expected stock return news, but not related to cash-flow news. Fourth, under the model of excess stock return variance, unexpected market liquidity and unexpected liquidity risk are negatively related to cash-flow news, expected excess stock return news, and interest rate news.     

Some tests of the government's intertemporal budget constraint using US data

US monthly data, for the period 1951–1984, are used to test a key element of the Ricardian equivalence doctrine, namely the government's intertemporal budget constraint. It is demonstrated that the US empirical evidence is not supportive of this constraint. Some explanations for this finding are noted.     

The government behavioural constraint in rational expectations models

Models with rational expectations typically include state variables whose values are controlled by the government. Hence, the need to specify behavioural rules for the authorities. Our purpose is to show, in the context of a well-known Cagan type model of the demand for money, that the assumption of rational expectations imposes the hitherto neglected requirement of rationality of the postulated behaviour of government. In particular the occurance of non-unique solutions highlights the need for a rational choice between these on grounds other than mathematical convenience or ad hoc economic assumptions of minimum variance, terminal conditions etc.