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The Costs of Fiscal Inflexibility - Extended

  • Campbell Leith
  • Simon Wren-Lewis

Extending Gali and Monacelli (2004 ), we build an N-country open economy model, where each economy is subject to sticky wages and prices and, potentially, has access to sales and income taxes as well as government spending as fiscal instruments. We examine an economy either as a small open economy under flexible exchange rates or as a (small) member of a monetary union. In a small open economy when all three fiscal instruments are freely available, we show analytically that the impact of technology and mark-up shocks can be completely eliminated, whether policy acts with discretion or commitment. However, once any one of these fiscal instruments is excluded as a stabilisation tool, costs can emerge. Using simulations, we find that the useful fiscal instrument in this case (in the sense of reducing the welfare costs of the shock) are sales taxes. In contrast, having government spending as an instrument contributes very little. In the case of mark-up shocks tax instruments which can offset the impact of the shock directly are highly effective, while other fiscal instruments are less useful. The results for an individual member of a monetary union facing an idiosyncratic technology shock (where monetary policy in the union does not respond) are very different. First, even with all fiscal instruments freely available, the technology shock will incur welfare costs. Second, government spending is potentially useful as a stabilisation device, because it can act as a partial substitute for monetary policy. Finally, income taxes are helpful in reducing the cost of a technology shock, although sales taxes remain the most effective instrument. If all three taxes are available, they can reduce the impact of the technology shock on the union member by around a half, compared to the case where fiscal policy is not used. Finally we consider the robustness of these results to two extensions. Firstly, introducing implementation lags in the use of fiscal instruments and, secondly, introducing government debt, such that policy makers take account of the debt consequences of using fiscal instruments as stabilisation devices. We find that implementation lags can reduce, but not eliminate, the gains from fiscal stabilisation, while the need for debt sustainability has limited impact on the use of fiscal instruments for stabilisation purposes, particularly under commitment..

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2005_23.

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Date of creation: Oct 2006
Date of revision:
Handle: RePEc:gla:glaewp:2005_23
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  1. Benigno, Pierpaolo & Woodford, Michael, 2004. "Optimal monetary and fiscal policy: a linear-quadratic approach," Working Paper Series 0345, European Central Bank.
  2. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
  3. Campbell Leith & Simon Wren-Lewis, 2006. "Fiscal Sustainability in a New Keynesian Model," Working Papers 2006_11, Business School - Economics, University of Glasgow, revised Nov 2008.
  4. Jordi Gali & Tommaso Monacelli, 2005. "Optimal fiscal policy in a monetary union," Proceedings, Federal Reserve Bank of San Francisco.
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