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Optimal fiscal policy

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  • Lukkezen, Jasper
  • Teulings, Coen N

Abstract

This paper derives and estimates rules for fiscal policy that prescribe the optimal response to changes in unemployment and debt. We combine the reducedform model of the economy from a linear VAR with a non-linear welfare function and obtain analytic solutions for optimal policy. The variables in our reducedform model – growth, unemployment, primary surplus – have a natural rate that cannot be affected by policy. Policy can only reduce fluctuations around these natural rates. Our welfare function contains future GDP and unemployment, the relative weights of which determine the optimal response. The optimal policy rule demands an immediate and large policy response that is procyclical to growth shocks and countercyclical to unemployment shocks. This result holds true when the weight of unemployment in the welfare function is reduced to zero. The rule currently followed by policy makers responds procyclically to both growth and unemployment shocks, and does so much slower than the optimal rule, leading to significant welfare losses.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9473.

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Date of creation: May 2013
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Handle: RePEc:cpr:ceprdp:9473

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Keywords: debt sustainability; fiscal consolidation; fiscal policy rules; optimal control; optimal policy;

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Blog mentions

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  1. Reduced form welfare
    by Economic Logician in Economic Logic on 2013-05-14 14:13:00

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