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Fiscal Rules and Discretion Under Persistent Shocks

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  • Marina Halac
  • Pierre Yared

Abstract

This paper studies the optimal level of discretion in policymaking. We consider a fiscal policy model where the government has time‐inconsistent preferences with a present bias toward public spending. The government chooses a fiscal rule to trade off its desire to commit to not overspend against its desire to have flexibility to react to privately observed shocks to the value of spending. We analyze the optimal fiscal rule when the shocks are persistent. Unlike under independent and identically distributed shocks, we show that the ex ante optimal rule is not sequentially optimal, as it provides dynamic incentives. The ex ante optimal rule exhibits history dependence, with high shocks leading to an erosion of future fiscal discipline compared to low shocks, which lead to the reinstatement of discipline. The implied policy distortions oscillate over time given a sequence of high shocks, and can force the government to accumulate maximal debt and become immiserated in the long run.

Suggested Citation

  • Marina Halac & Pierre Yared, 2014. "Fiscal Rules and Discretion Under Persistent Shocks," Econometrica, Econometric Society, vol. 82, pages 1557-1614, September.
  • Handle: RePEc:wly:emetrp:v:82:y:2014:i::p:1557-1614
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    References listed on IDEAS

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    Cited by:

    1. Waki, Yuichiro & Dennis, Richard & Fujiwara, Ippei, 0. "The optimal degree of monetary-discretion in a New Keynesian model with private information," Theoretical Economics, Econometric Society.
    2. repec:rsr:supplm:v:65:y:2017:i:5:p:122-138 is not listed on IDEAS
    3. Cunha, Alexandre B. & Ornelas, Emanuel, 2014. "Political Competition and the Limits of Political Compromise," CEPR Discussion Papers 9909, C.E.P.R. Discussion Papers.
    4. Frederic Cherbonnier, 2016. "optimal insurance for time-inconsistent agents," 2016 Meeting Papers 1344, Society for Economic Dynamics.
    5. Bowen, T. Renee & Chen, Ying & Eraslan, Hülya & Zápal, Jan, 2017. "Efficiency of flexible budgetary institutions," Journal of Economic Theory, Elsevier, vol. 167(C), pages 148-176.
    6. Falilou Fall & Debra Bloch & Jean-Marc Fournier & Peter Hoeller, 2015. "Prudent debt targets and fiscal frameworks," OECD Economic Policy Papers 15, OECD Publishing.
    7. Rodrigo Harrison & Roger Lagunoff, 2017. "Dynamic Mechanism Design For A Global Commons," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 58, pages 751-782, August.
    8. Cunha, Alexandre B. & Ornelas, Emanuel, 2017. "The Limits of Political Compromise: Debt Ceilings and Political Turnover," CEPR Discussion Papers 11945, C.E.P.R. Discussion Papers.
    9. Marina Azzimonti, 2016. "The Politics of FDI Expropriation," NBER Working Papers 22705, National Bureau of Economic Research, Inc.
    10. Désirée Christofzik & Sebastian Kessing, 2014. "Does Fiscal Oversight Matter?," CESifo Working Paper Series 5023, CESifo Group Munich.
    11. Azzimonti, Marina & Battaglini, Marco & Coate, Stephen, 2016. "The costs and benefits of balanced budget rules: Lessons from a political economy model of fiscal policy," Journal of Public Economics, Elsevier, vol. 136(C), pages 45-61.
    12. Facundo Piguillem & Alessandro Riboni, 2015. "Spending-Biased Legislators: Discipline Through Disagreement," The Quarterly Journal of Economics, Oxford University Press, vol. 130(2), pages 901-949.
    13. R. Vijay Krishna & Shiming Fu, 2016. "Dynamic Financial Contracting with Persistent Private Information," 2016 Meeting Papers 89, Society for Economic Dynamics.
    14. Alex Clymo & Andrea Lanteri, 2016. "Fiscal Policy with Limited-Time Commitment," Tinbergen Institute Discussion Papers 16-056/VI, Tinbergen Institute.
    15. Karakas, Leyla D., 2016. "Political turnover and the accumulation of democratic capital," European Journal of Political Economy, Elsevier, vol. 44(C), pages 195-213.
    16. Rohit Lamba & Ilia Krasikov, 2017. "A Theory of Dynamic Contracting with Financial Constraints," 2017 Meeting Papers 1544, Society for Economic Dynamics.
    17. Martin, Fernando M., 2016. "The Value of Constraints on Discretionary Government Policy," Working Papers 2016-19, Federal Reserve Bank of St. Louis, revised 15 Feb 2017.
    18. Marina Halac & Pierre Yared, 2015. "Fiscal Rules and Discretion in a World Economy," NBER Working Papers 21492, National Bureau of Economic Research, Inc.
    19. G. Bellettini & P. Roberti, 2016. "Politicians' coherence and government debt," Working Papers wp1087, Dipartimento Scienze Economiche, Universita' di Bologna.
    20. repec:eee:macchp:v2-2599 is not listed on IDEAS
    21. Lizzeri, Alessandro & Yariv, Leeat, 2015. "Collective Self Control," CEPR Discussion Papers 10458, C.E.P.R. Discussion Papers.
    22. Francisco M. Gonzalez & Itziar Lazkano & Sjak A. Smulders, 2017. "Future-biased Intergenerational Altruism," Working Papers 1703, University of Waterloo, Department of Economics, revised Apr 2017.
    23. Alberto Alesina & Andrea Passalacqua, 2015. "The Political Economy of Government Debt," NBER Working Papers 21821, National Bureau of Economic Research, Inc.

    More about this item

    JEL classification:

    • D02 - Microeconomics - - General - - - Institutions: Design, Formation, Operations, and Impact
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • H1 - Public Economics - - Structure and Scope of Government
    • P16 - Economic Systems - - Capitalist Systems - - - Political Economy of Capitalism

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