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Precautionary Monetary and Fiscal Policies


  • Pelin Berkmen


This paper explains why the debt reduction motive for countries that are subject to borrowing constraints and a volatile environment is greater than for those with a more stable environment and relatively better access to the financial markets. In particular, it shows that the possibility of losing the ability to borrow in the future induces precautionary debt reduction. When a government loses its ability to borrow, shocks are more costly to the economy, since they cannot be spread over time. The precautionary motive arises from the need to make these adjustments less painful when the borrowing constraints bind. To avoid large losses in the constrained period, the government prefers to raise taxes and inflation in earlier periods more than would be implied otherwise, leaving less debt to the future periods, and thereby shifting some of the required adjustment to the earlier periods. In other words, the coexistence of large shocks and borrowing constraints forces the government to be more prudent in its management of debt.

Suggested Citation

  • Pelin Berkmen, 2007. "Precautionary Monetary and Fiscal Policies," IMF Working Papers 07/30, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:07/30

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    References listed on IDEAS

    1. Arminio Fraga & Ilan Goldfajn & André Minella, 2004. "Inflation Targeting in Emerging Market Economies," NBER Chapters,in: NBER Macroeconomics Annual 2003, Volume 18, pages 365-416 National Bureau of Economic Research, Inc.
    2. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
    3. Zeldes, Stephen P, 1989. "Consumption and Liquidity Constraints: An Empirical Investigation," Journal of Political Economy, University of Chicago Press, vol. 97(2), pages 305-346, April.
    4. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under sticky prices," Journal of Economic Theory, Elsevier, vol. 114(2), pages 198-230, February.
    5. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 1-74.
    6. repec:rus:hseeco:123922 is not listed on IDEAS
    7. Pierpaolo Benigno & Michael Woodford, 2004. "Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach," NBER Chapters,in: NBER Macroeconomics Annual 2003, Volume 18, pages 271-364 National Bureau of Economic Research, Inc.
    8. Olivier Blanchard, 2004. "Fiscal Dominance and Inflation Targeting: Lessons from Brazil," NBER Working Papers 10389, National Bureau of Economic Research, Inc.
    9. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-971, October.
    10. Mark Zelmer & Andrea Schaechter, 2000. "Adopting Inflation Targeting; Practical Issues for Emerging Market Countries," IMF Occasional Papers 202, International Monetary Fund.
    11. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
    12. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
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    Debt; Fiscal policy; Monetary policy; Precautionary Motive; inflation; rational expectations; inflation rate; inflation targeting;

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