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In Praise of Fiscal Restraint and Debt Rules. What the Euro Zone Might Do Now

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  • Hughes Hallett, Andrew

Abstract

This paper attempts to reconcile the need for flexibility in fiscal policy, with the need for credibility and consistency in monetary policies. The idea is to generate fewer conflicts between policies but greater discipline within them. We assume an independent central bank and restraints on the use of national fiscal policies. Using a theoretical model, we examine the consequences of assigning leadership to fiscal or monetary policies to exploit the implicit (rule based) coordination available under standard transmission mechanisms, but where priorities and targets differ between policy makers. This works best with fiscal leadership: we introduce a debt rule (with hard or soft targets) to precommit fiscal policies over the longer term, but use monetary independence to guarantee credibility and discipline in the short run stabilization policies. Compared to the uncoordinated solution now operating in Europe, inflation biases are lower and debt repayments higher for no loss in output volatility. That corresponds to the experience of the UK, our benchmark case, whose empirical reaction functions show fiscal leadership. Across ten OECD countries, these gains are estimated to be worth 2%-4% of GDP.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5043.

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Date of creation: May 2005
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Handle: RePEc:cpr:ceprdp:5043

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Keywords: debt rule; institutional coordination; soft targets; stackelberg leadership;

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References

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  1. Andrew Hughes Hallett & Diana N. Weymark, 2005. "Independence Before Conservatism: Transparency, Politics and Central Bank Design," German Economic Review, Verein für Socialpolitik, vol. 6(1), pages 1-21, 02.
  2. Hughes Hallett, Andrew & Weymark, Diana N., 2004. "Independent monetary policies and social equity," Economics Letters, Elsevier, vol. 85(1), pages 103-110, October.
  3. Hughes Hallett, A J, 1984. "Non-cooperative Strategies for Dynamic Policy Games and the Problem of Time Inconsistency," Oxford Economic Papers, Oxford University Press, vol. 36(3), pages 381-99, November.
  4. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  5. Dieppe, Alistair & Kuester, Keith & McAdam, Peter, 2004. "Optimal monetary policy rules for the euro area: an analysis using the area wide model," Working Paper Series 0360, European Central Bank.
  6. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
  7. Brandsma, Andries S. & Hughes Hallett, A. J., 1984. "Economic conflict and the solution of dynamic games," European Economic Review, Elsevier, vol. 26(1-2), pages 13-32.
  8. Robert J. Barro, 1980. "Output Effects of Government Purchases," NBER Working Papers 0432, National Bureau of Economic Research, Inc.
  9. Jordi Gali & Roberto Perotti, 2003. "Fiscal Policy and Monetary Integration in Europe," NBER Working Papers 9773, National Bureau of Economic Research, Inc.
  10. Avinash Dixit & Luisa Lambertini, 2003. "Interactions of Commitment and Discretion in Monetary and Fiscal Policies," Boston College Working Papers in Economics 575, Boston College Department of Economics.
  11. Francesco Saraceno & Paola Monperrus-Veroni, 2004. "A Simple Proposal for a 'Debt-Sensitive Stability Pact'," Macroeconomics 0406001, EconWPA.
  12. Andrew Hallett & Nicola Viegi, 2002. "Inflation Targeting as a Coordination Device," Open Economies Review, Springer, vol. 13(4), pages 341-362, October.
  13. Andrew Hughes Hallett & Diana N. Weymark, 2002. "Government Leadership and Central Bank Design," Vanderbilt University Department of Economics Working Papers 0208, Vanderbilt University Department of Economics, revised Dec 2004.
  14. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  15. Marco Buti & Sylvester Eijffinger & Daniele Franco, 2003. "Revisiting the Stability and Growth Pact: grand design or internal adjustment?," European Economy - Economic Papers 180, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission.
  16. A.J. Hallet, 1998. "When Do Target Zones Work? An Examination of Exchange Rate Targeting as a Device for Coordinating Economic Policies," Open Economies Review, Springer, vol. 9(2), pages 115-138, April.
  17. Dixit, Avinash, 2001. "Games of monetary and fiscal interactions in the EMU," European Economic Review, Elsevier, vol. 45(4-6), pages 589-613, May.
  18. Jacob Frenkel & Morris Goldstein & Paul Masson, 1990. "The Rationale for, and Effects of, International Economic Policy Coordination," NBER Chapters, in: International Policy Coordination and Exchange Rate Fluctuations, pages 9-62 National Bureau of Economic Research, Inc.
  19. Andrew Hughes Hallett & Diana N. Weymark, 2002. "Policy Games and the Optimal Design of Central Banks," Vanderbilt University Department of Economics Working Papers 0220, Vanderbilt University Department of Economics.
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Citations

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Cited by:
  1. Andrew Hughes Hallett & Moritz Kuhn & Thomas Warmedinger, 2012. "The gains from early intervention in Europe: Fiscal surveillance and fiscal planning using cash data," European Journal of Government and Economics, Europa Grande, vol. 1(1), pages 44-65, June.
  2. Andrew Hughes Hallett, 2008. "Coordination without Explicit Cooperation: Monetary-Fiscal Interactions in an Era of Demographic Change," European Economy - Economic Papers 305, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission.
  3. Casimir Dadak, 2011. "Political Economy of the Euro Area Crisis," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 58(5), pages 593-604, December.
  4. Kirsanova, Tatiana & Stehn, Sven Jari & Vines, David, 2006. "Five-Equation Macroeconomics: A Simple View of the Interactions Between Fiscal Policy and Monetary Policy," CEPR Discussion Papers 5464, C.E.P.R. Discussion Papers.
  5. J. James Reade, 2011. "Modelling Monetary and Fiscal Policy in the US: A Cointegration Approach," Discussion Papers 11-02, Department of Economics, University of Birmingham.

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