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Fiscal Policy And Budget Deficit Stability In A Continuous Time Stochastic Economy


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  • Joao L.M. Amador

    (Universidade Nova de Lisboa)


The study of fiscal policy and budget deficits has been an active field of research in economic theory throughout the decades. This literature has addressed very different questions such as the consequences of running budget deficits, the optimal financing of budget deficits or the required conditions to avoid an unsustainable path for the public debt. Nowadays, fiscal policy analysis has gained increased interest in the face of the new monetary union in Europe. In fact, public spending and taxation are the remaining major policy instruments available for the countries participating in the monetary union. Therefore, it is vital to know how should countries set fiscal parameters and their consequences on general macroeconomic performance. Furthermore, to run large budget deficits in a monetary union can become a serious problem. As a matter of fact, if a country cannot finance the budget deficit in each moment it will either default, creating a problem in the bond market of the monetary area, or be bailed-out by a central authority. It is known that the domestic monetarization of budget deficits is no longer an available solution in monetary unions. This type of concerns has lead to the setting of guidelines for the budget deficits and public debt in the countries that would take part in the European Monetary Union. The Maastricht treaty transformed these guidelines into pre-entry conditions, and more recently, the Stability and Growth Pact adopted them as rules for the future of the monetary union. Therefore, it is very important to characterize the stationary equilibrium path of the budget deficit. There are several studies focusing on these topics. Many of them examine the effects of fiscal policy and the budget deficits. A short and incomplete list of such studies includes Blanchard (1985), Barro (1989), Bernheim (1989), Emerson et al (1992). Other studies clearly deal with the question of the sustainability of the budget deficit. In this group we include Nielsen (1992), Bohn (1995), Perotti, Strauch and von Hagen (1998) and Mongelli (1999). The aim of this paper is to develop a general equilibrium continuous time stochastic model, stressing the role of fiscal policy and the behavior of budget deficit and public debt. An important feature of the model is the definition of the sources of uncertainty as stochastic processes and the utilization of stochastic optimization methods, such as in Turnovsky (1995) and (1997). This author presents a general framework that is wider than the one adopted here, but assumes that taxation endogenously adjusts fiscal imbalances. We reduce the number of variables in the economy and focus instead on the endogenous determination of the public bond market equilibrium, and on its effects on the budget deficit. One of the simplifying assumptions is to consider a non-monetary economy. It is true that this hypothesis limits the analysis of important features such as inflation or the monetary financing of budget deficits. However, it may not be restrictive in the case of monetary unions where the central bank follows a low inflation oriented monetary policy and refuses to bail out single countries. This is clearly the case in the European Union. Another simplifying assumption is to consider a closed economy. This limits the ability of the government to sell public bonds abroad, which has obvious consequences on the budget deficit. Despite important, we argue later that this assumption does not change the main results of the paper and allows for a clear analysis of what is behind the sustainability of budget deficits. Within this framework, we endogenously obtain an expression for the equilibrium budget deficit as a percentage of deterministic output and an expression for the public bond's equilibrium interest rate. In addition, it is possible to determine the equilibrium growth rate of the economy and the weight of capital stock and public bonds on total wealth. These results provide answers to some important questions, namely to know what are the major determinants of the equilibrium budget deficit, how to assure the sustainability of public debt, how is the growth rate of the economy affected by fiscal policy and how does uncertainty affect the results. The paper concludes that changes on the tax rate, on average public spending and on the properties of the shocks that affect the economy lead to unsustainable budget deficit behavior. These changes define structural shocks on the stationary equilibrium, which can only be compensated through additional changes in structural parameters. On the contrary, short run shocks on technology and public expenditure are part of the stationary equilibrium and consistent with budget deficit stability. In addition, it is shown that the stationary equilibrium in economies with low tax rates and high public spending must be associated with a low public debt-wealth ratio and a low budget deficit. The same is true for economies facing a high volatility on technology and expenditure shocks. The paper is divided into eight sections. In the next section we present the continuous time stochastic economy. We describe production technology as well as the problem of the representative consumer. Next, we present the optimum conditions of the problem. In the third section we introduce public expenditure and define both budget deficits and public bond market equilibrium. Then, in the fourth section, a partial equilibrium analysis is presented. In the fifth section the general equilibrium solution of the model is obtained. Then, in the sixth section, we examine how changes in fiscal policy and uncertainty parameters affect the equilibrium. Moreover, we analyze the consequences of these changes in terms of the path of the deficit. In the seventh section simulation methods are used to examine different scenarios and to plot the path of the variables in the stationary equilibrium. Finally, section eight presents some concluding remarks.

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2000 with number 27.

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Date of creation: 05 Jul 2000
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Handle: RePEc:sce:scecf0:27

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Postal: CEF 2000, Departament d'Economia i Empresa, Universitat Pompeu Fabra, Ramon Trias Fargas, 25,27, 08005, Barcelona, Spain
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  1. Corsetti, Giancarlo, 1997. "A portfolio approach to endogenous growth: equilibrium and optimal policy," Journal of Economic Dynamics and Control, Elsevier, vol. 21(10), pages 1627-1644, August.
  2. Bernheim, B Douglas, 1989. "A Neoclassical Perspective on Budget Deficits," Journal of Economic Perspectives, American Economic Association, vol. 3(2), pages 55-72, Spring.
  3. Kenen,Peter B., 1995. "Economic and Monetary Union in Europe," Cambridge Books, Cambridge University Press, number 9780521558839.
  4. Bohn, Henning, 1995. "The Sustainability of Budget Deficits in a Stochastic Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(1), pages 257-71, February.
  5. Stephen J. Turnovsky, 1997. "International Macroeconomic Dynamics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201119, December.
  6. Olivier J. Blanchard, 1984. "Debt, Deficits and Finite Horizons," NBER Working Papers 1389, National Bureau of Economic Research, Inc.
  7. Poterba, James M, 1996. "Budget Institutions and Fiscal Policy in the U.S. States," American Economic Review, American Economic Association, vol. 86(2), pages 395-400, May.
  8. Robert J. Barro, 1988. "The Ricardian Approach to Budget Deficits," NBER Working Papers 2685, National Bureau of Economic Research, Inc.
  9. Alesina, Alberto & Perotti, Roberto, 1996. "Fiscal Discipline and the Budget Process," American Economic Review, American Economic Association, vol. 86(2), pages 401-07, May.
  10. Søren Bo Nielsen, 1991. "A Note on the Sustainability of Primary Budget Deficits," Discussion Papers 91-03, University of Copenhagen. Department of Economics.
  11. Francesco P. Mongelli, 1996. "The Effects of the European Economic and Monetary Union (EMU)on National Fiscal Sustainability," IMF Working Papers 96/72, International Monetary Fund.
  12. Torres,Francisco & Giavazzi,Francesco (ed.), 1993. "Adjustment and Growth in the European Monetary Union," Cambridge Books, Cambridge University Press, number 9780521440196.
  13. Olivier Jean Blanchard & Stanley Fischer, 1989. "Lectures on Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262022834, December.
  14. Perotti, Roberto & Strauch, Rolf & von Hagen, Jürgen, 1997. "Sustainability of Public Finances," CEPR Discussion Papers 1781, C.E.P.R. Discussion Papers.
  15. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  16. Emerson, Michael & Gros, Daniel & Italianer, Alexander & ,, 1992. "One Market, One Money: An Evaluation of the Potential Benefits and Costs of Forming an Economic and Monetary Union," OUP Catalogue, Oxford University Press, number 9780198773245, September.
  17. Eichengreen, Barry, 1993. "European Monetary Unification," Journal of Economic Literature, American Economic Association, vol. 31(3), pages 1321-57, September.
  18. Alberto Alesina & Roberto Perotti, 1994. "The Political Economy of Budget Deficits," NBER Working Papers 4637, National Bureau of Economic Research, Inc.
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Cited by:
  1. Thierry Warin, 2005. "Stability and Growth Pact: An Index to Trigger an Early Warning Earlier?," Middlebury College Working Paper Series 0502, Middlebury College, Department of Economics.
  2. Amador, Joao L. M., 1999. "Optimal Budget Deficit Rules," FEUNL Working Paper Series wp385, Universidade Nova de Lisboa, Faculdade de Economia.
  3. Thierry Warin & Kenneth Donahue, 2006. "The Stability and Growth Pact: A European Answer to the Political Budget Cycle?," Middlebury College Working Paper Series 0606, Middlebury College, Department of Economics.


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