Fiscal Policy in a Stock-Flow consistent (SFC) Model: A Comment

This comment provides a simple analytical exposition of the stock-flow consistent closed economy model used by Godley and Lavoie (2007b) to argue a case for fiscal stabilization policy. We show that the government spending stabilisation rule proposed by Godley and Lavoie (GL) is equivalent to an optimal-output budget deficit rule that automatically ensures budget solvency as long as private sector saving behaviour is itself stable. Assuming a non-inflationary full-employment objective, we derive an optimal government-spending rule. We endorse GL's view that fiscal policy needs to be "appropriate" if monetary policy is to be actively pursued. The main requirement of fiscal policy is a government debt rule to avoid instabilities arising from the accumulation of debt interest payments. Godley and Lavoie (2007a) simulate such instabilities but do not propose a solution. We do so and derive an optimal monetary rule. The theoretical substitutability of policy rules raises important questions about the wisdom of macroeconomic stabilization strategies that relegate fiscal policy to a purely supporting role.