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Precautionary Monetary and Fiscal Policies

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  • Pelin Berkmen
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    Abstract

    This paper explains why the debt reduction motive for countries that are subject to borrowing constraints and a volatile environment is greater than for those with a more stable environment and relatively better access to the financial markets. In particular, it shows that the possibility of losing the ability to borrow in the future induces precautionary debt reduction. When a government loses its ability to borrow, shocks are more costly to the economy, since they cannot be spread over time. The precautionary motive arises from the need to make these adjustments less painful when the borrowing constraints bind. To avoid large losses in the constrained period, the government prefers to raise taxes and inflation in earlier periods more than would be implied otherwise, leaving less debt to the future periods, and thereby shifting some of the required adjustment to the earlier periods. In other words, the coexistence of large shocks and borrowing constraints forces the government to be more prudent in its management of debt.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/30.

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    Length: 27
    Date of creation: 01 Feb 2007
    Date of revision:
    Handle: RePEc:imf:imfwpa:07/30

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    1. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
    2. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
    3. Pierpaolo Benigno & Michael Woodford, 2004. "Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach," NBER Chapters, in: NBER Macroeconomics Annual 2003, Volume 18, pages 271-364 National Bureau of Economic Research, Inc.
    4. repec:rus:hseeco:123922 is not listed on IDEAS
    5. Zeldes, Stephen P, 1989. "Consumption and Liquidity Constraints: An Empirical Investigation," Journal of Political Economy, University of Chicago Press, vol. 97(2), pages 305-46, April.
    6. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 1-74.
    7. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
    8. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
    9. Arminio Fraga & Ilan Goldfajn & Andre Minella, 2003. "Inflation Targeting in Emerging Market Economies," NBER Working Papers 10019, National Bureau of Economic Research, Inc.
    10. Olivier Blanchard, 2004. "Fiscal Dominance and Inflation Targeting: Lessons from Brazil," NBER Working Papers 10389, National Bureau of Economic Research, Inc.
    11. Marc Zelmer & Andrea Schaechter, 2000. "Adopting Inflation Targeting," IMF Occasional Papers 202, International Monetary Fund.
    12. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under sticky prices," Journal of Economic Theory, Elsevier, vol. 114(2), pages 198-230, February.
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