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Optimal fiscal and monetary policies in the face of rare disasters

  • Niemann, Stefan
  • Pichler, Paul

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.

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File URL: http://www.sciencedirect.com/science/article/pii/S0014-2921(10)00102-9
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Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 55 (2011)
Issue (Month): 1 (January)
Pages: 75-92

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Handle: RePEc:eee:eecrev:v:55:y:2011:i:1:p:75-92
Contact details of provider: Web page: http://www.elsevier.com/locate/eer

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  1. Fernando Martin, 2009. "A Positive Theory of Government Debt," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 608-631, October.
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  11. Campbell Leith & Simon Wren-Lewis, 2010. "Discretionary policy in a monetary union with sovereign debt," Working Papers 2010_23, Business School - Economics, University of Glasgow.
  12. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
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  28. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, Oxford University Press, vol. 123(4), pages 1415-1464.
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