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Optimal Fiscal Policy and the Banking Sector

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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

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Bibliographic Info

Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2012-40.

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Length: 71 pages
Date of creation: Nov 2012
Date of revision: Jul 2013
Handle: RePEc:uct:uconnp:2012-40

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Web page: http://www.econ.uconn.edu/
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  1. Ben Lockwood, 2010. "How Should Financial Intermediation Services be Taxed?," Working Papers 1014, Oxford University Centre for Business Taxation.
  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, 2005. "Optimal Taxation in an RBC Model: A Linear-Quadratic Approach," NBER Working Papers 11029, National Bureau of Economic Research, Inc.
  4. Martin Berka & Christian Zimmermann, 2012. "Basel Accord and Financial Intermediation: The Impact of Policy," Working Paper Series 04_12, The Rimini Centre for Economic Analysis.
  5. Michael Kumhof & Evan Tanner, 2005. "Government Debt," IMF Working Papers 05/57, International Monetary Fund.
  6. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal fiscal policy in a business cycle model," Staff Report 160, Federal Reserve Bank of Minneapolis.
  7. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  8. Meh, Césaire A. & Moran, Kevin, 2010. "The role of bank capital in the propagation of shocks," Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 555-576, March.
  9. Hansen, Gary D., 1985. "Indivisible labor and the business cycle," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 309-327, November.
  10. Sonali Das & Amadou N. R. Sy, 2012. "How Risky Are Banks' Risk Weighted Assets? Evidence From the Financial Crisis," IMF Working Papers 12/36, International Monetary Fund.
  11. Dellas, H. & Diba, B. & Loisel, O., 2010. "Financial Shocks and Optimal Policy," Working papers 277, Banque de France.
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