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Optimal fiscal and monetary policies in the face of rare disasters

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  • Niemann, Stefan
  • Pichler, Paul

Abstract

This paper studies optimal fiscal and monetary policies in an economy exposed to large adverse shocks (rare disasters). We contrast optimal policies under commitment and discretion and identify several striking differences between these institutional environments. A government that can commit to its policy plans relies heavily on debt to smooth the adverse effects of large shocks over time. Lack of commitment seriously limits the government's ability to use debt as a shock absorber. Under discretion, an increase in debt leads to an increase in inflation expectations and therefore higher nominal interest rate distortions. Hence, the discretionary government keeps debt in close vicinity of its steady-state level, and the response of taxes, inflation, and interest rates to shocks is much more pronounced under discretion than under commitment. This is particularly relevant for large shocks and when the initial stock of government debt is already high at the time the shock occurs. We also argue that the adverse welfare effects of disasters are larger under discretion than under commitment, but these welfare differentials can be significantly reduced by making the discretionary government inflation averse.

Suggested Citation

  • Niemann, Stefan & Pichler, Paul, 2011. "Optimal fiscal and monetary policies in the face of rare disasters," European Economic Review, Elsevier, vol. 55(1), pages 75-92, January.
  • Handle: RePEc:eee:eecrev:v:55:y:2011:i:1:p:75-92
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    Cited by:

    1. repec:taf:oabmxx:v:3:y:2016:i:1:p:1154283 is not listed on IDEAS
    2. Eric M Leeper & Campbell Leith & Ding Liu, 2016. "Optimal Time-Consistent Monetary, Fiscal and Debt Maturity Policy," Working Papers 2016_04, Business School - Economics, University of Glasgow.
    3. Toshiki JINUSHI & Nobuyuki ISAGAWA & Kozo HARIMAYA, 2013. "Monetary Policy and Natural Disasters: An Extension and Simulation Analysis in the Framework of New Keynesian Macroeconomic Model," APIR Discussion Paper Series 1001783, Asia Pacific Institute of Research.
    4. Mitsuhiro Okano, 2013. "Monetary Policy and Natural Disasters: An Extension and Simulation Analysis in the Framework of New Keynesian Macroeconomic Model," APIR Discussion Paper Series 32, Asia Pacific Institute of Research.
    5. Giorgio Motta & Raffaele Rossi, 2013. "Ramsey monetary and fiscal policy: the role of consumption taxation," Working Papers 44449031, Lancaster University Management School, Economics Department.

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