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Optimal Fiscal Policy and the Banking Sector

Author

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  • Matthew Schurin

    (University of Connecticut)

Abstract

What should the government’s fiscal policy be when banks hold significant amounts of public debt and the government can default on its debt obligations? This question is addressed using a dynamic stochastic general equilibrium model where banks face constraints on their leverage ratios and adjust lending to satisfy regulatory requirements. In response to negative productivity shocks, the government subsidizes the banking sector by increasing bond repayments. This helps to sustain private sector lending. When government consumption exogenously increases, however, the government optimally taxes banks and partially defaults on its debt. Debt issuance is procyclical to ensure equilibrium in the deposit market. With an opening of the economy, the government uses less aggressive tax and default policies. JEL Classification: E32, E62, F41, H21, H63 Key words: Business Fluctuations, Debt, Fiscal Policy, Government Bonds, Ramsey Equilibrium, Optimal Taxation

Suggested Citation

  • Matthew Schurin, 2012. "Optimal Fiscal Policy and the Banking Sector," Working papers 2012-40, University of Connecticut, Department of Economics, revised Jul 2013.
    • Handle: RePEc:uct:uconnp:2012-40
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    References listed on IDEAS

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    More about this item

    Keywords

    business fluctuations; debt; fiscal policy; government bonds; ramsey equilibrium; optimal taxation;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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