Fiscal policy and financial market movements

This paper estimates fiscal policy reaction function in order to investigate the links between financial market movements and fiscal policy outcomes. An increase in asset prices affects in a positive and significant manner primary balances, with the response reflecting both an increase in government revenues and a fall in government spending. The most important impact on fiscal balances is due to changes in residential property prices. Changes in equity and commercial property prices are also important determinants of fiscal balances. Our findings suggest that the steepening of the slope of the yield curve contributes to expenditure based fiscal discipline.     

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.     

Monetary conservatism and fiscal policy

Does an inflation conservative central bank à la Rogoff (1985) remain desirable in a setting with endogenous fiscal policy? To provide an answer we study monetary and fiscal policy games without commitment in a dynamic, stochastic sticky-price economy with monopolistic distortions. Monetary policy determines nominal interest rates and fiscal policy provides public goods generating private utility. We find that lack of fiscal commitment gives rise to excessive public spending. The optimal inflation rate internalizing this distortion is positive, but lack of monetary commitment generates too much inflation. A conservative monetary authority thus remains desirable. When fiscal policy is determined before monetary policy each period, the monetary authority should focus exclusively on stabilizing inflation. Monetary conservatism then eliminates the steady state biases associated with lack of monetary and fiscal commitment and leads to stabilization policy that is close to optimal.     

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.     

Optimal sustainable monetary policy

In recent monetary policy literature, optimal commitment policy and its variant from a timeless perspective have been studied with emphasis on welfare gains from policy commitment. These policies, however, involve a time-consistency problem called a stabilization bias in forward-looking models. We analyze Chari and Kehoe's [1990. Sustainable plans. Journal of Political Economy 98, 783-802] sustainable equilibrium and examine optimal sustainable policy, i.e. a policymaker's strategy in the best sustainable equilibrium. This paper shows that such a policy becomes consistent with the optimal commitment policy in sufficiently later periods. It also shows that whether the optimal sustainable policy can attain the Ramsey equilibrium outcome depends on the magnitude of shocks hitting the model economy. Moreover, the paper finds a sustainable policy that attains higher social welfare than discretionary policy does.     

On the optimal timing of capital taxes

For many kinds of capital, depreciation rates change systematically with the age of the capital. Consider an example that captures essential aspects of human capital, both regarding its accumulation and its depreciation: a worker obtains knowledge in period 0, then uses this knowledge in production in periods 1 and 2, and thereafter retires. Here, depreciation accelerates: it occurs at a 100% rate after period 2, and at a lower (perhaps zero) rate before that. The present paper analyzes the implications of non-constant depreciation rates for the optimal timing of taxes on capital income. The main finding is that under natural assumptions, the path of tax rates over time must be oscillatory. Oscillatory tax rates are optimal when depreciation rates accelerate with the age of the capital (as in the above example), and provided that the government can commit to the path of future tax rates but cannot apply different tax rates in a given year to different vintages of capital.     

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.     

Did the repeated debt ceiling controversies embed default risk in US Treasury securities?

We examine whether the financial market charged a default risk premium to US Treasury securities when the US Federal government repeatedly reached the legally binding debt limits between 2002 and 2006. We show that for the first two of the four recurrences since the first episode in 1996, the financial market charged a small default risk premium to the Treasury securities. However, we find no significant evidence of a pricing effect in the last two recurrences. The results suggest that the financial market gradually perceived the budget standoffs as the boy who cried wolf.     

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.     

Optimal Fiscal Policy with Consumption Taxation

We characterize optimal fiscal policies in a general equilibrium model with monopolistic competition and endogenous public spending. The government can tax consumption, as alternative to labor income taxes. Consumption taxation acts as indirect taxation of profits (intratemporal gains of taxing consumption) and enables the policymaker to manage the burden of public debt more efficiently (intertemporal gains of taxing consumption). We show analytically that these two gains imply that the optimal share of government spending is higher under consumption taxation than with labor income taxation. Then, we quantify numerically each of these gains by calibrating the model on the U.S. economy.     

Quantifying tax effects under policy foresight

Studies of tax effects make the conventional information assumption that changes in period-t taxes become known at t. Legislative lags, however, imply that news arrives before tax changes take place. Under policy foreknowledge, the conventional information structure is therefore misspecified. Simulations of a standard neoclassical growth model suggest that foresight of only one quarter can distort substantially the estimates of tax effects obtained under the no-foresight assumption. Also, it is crucial to model capital and labor taxes separately: anticipated changes in these two tax policies have opposite effects on consumption, investment, labor, and output before policy realization.     

A general theory of controllability and expectations anchoring for small-open economies

Rational expectations are often used as an argument against policy activism, as they may undermine or neutralize the policymaker’s actions. Although this sometimes happens, rational expectations do not always imply policy invariance or ineffectiveness. In fact, in certain circumstances rational expectations can enhance our power to control an economy over time. In those cases, policy announcements can be used to extend the impact of conventional policy instruments. We present a general forward-looking policy framework and use it to provide a formal rationale for testing when policymakers can and cannot expect to be able to manage expectations. To describe the relevance of our results applications are shown for policy design in small-open economies. Those are the cases where domestic policies are at their weakest and our ability to influence expectations most constrained.     

The Friedman rule: Old and new

In overlapping generations models, money growth creates intergenerational wealth effects and leads to the breakdown of the Friedman rule; the rule can be restored via lump-sum tax and transfers that neutralize these wealth transfers. Additionally, and in contrast to money-in-the-utility-function models, the Friedman rule is not the unique first-best solution in cash-in-advance-constraint models of money: a continuum of combinations of money growth rates and consumption taxes implement the first-best allocation. This paper traces through the intellectual origins of the first (old) result, which was recently restated in Bhattacharya, et al. [2005. Monetary policy, fiscal policy, and the inflation tax: equivalence results. Macroeconomic Dynamics 7, 647-669.] and formally demonstrates the second (new) result.     

Nonseparable Preferences, Fiscal Policy Puzzles, and Inferior Goods

Nonseparable preferences over consumption and leisure can generate an increase in private consumption in response to government spending, as found in the data, in a frictionless business cycle model. However, the conditions on preferences required for these result to obtain hold if and only if the consumption good is inferior. Similarly, positive co-movement of consumption and hours worked occurs if and only if either consumption or leisure is inferior.     

The increasing default risk of US Treasury securities due to the financial crisis

This paper examines the impact of the current financial crisis on long-term US Treasury yields by testing the impact of a series of events from December 2007 to March 2009 on the spread between 10-year USD LIBOR swap and 10-year US Treasury (constant maturity) rates to measure risk associated with Treasuries. Controlling for the liquidity of the two markets, the default risk of the swap, and the net foreign purchases of Treasury securities, we find that 13 of the tested 20 events have significantly negative coefficients. We conclude that the lower spread is consistent with greater default risk for US Treasury securities.