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Fiscal Rules and Discretion under Persistent Shocks

  • Marina Halac
  • Pierre Yared

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 towards 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 i.i.d. 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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18545.

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Date of creation: Nov 2012
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Publication status: published as Fiscal Rules and Discretion Under Persistent Shocks Marina Halac1,2 andPierre Yared1,3,† Article first published online: 3 OCT 2014 DOI: 10.3982/ECTA11207 © 2014 The Econometric Society Issue Econometrica Econometrica Volume 82, Issue 5, pages 1557–1614, September 2014
Handle: RePEc:nbr:nberwo:18545
Note: EFG POL
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  1. Battaglini, Marco & Coate, Stephen, 2007. "A Dynamic Theory of Public Spending, Taxation and Debt," Working Papers 07-04, Cornell University, Center for Analytic Economics.
  2. Pierre Yared, 2010. "Politicians, Taxes and Debt," Review of Economic Studies, Oxford University Press, vol. 77(2), pages 806-840.
  3. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  4. Bruno Strulovici, 2011. "Renegotiation-Proof Contracts with Moral Hazard and Persistent Private Information," Discussion Papers 1519, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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  6. Alberto Alesina & Roberto Perotti, 1994. "The Political Economy of Budget Deficits," NBER Working Papers 4637, National Bureau of Economic Research, Inc.
  7. Ricardo J. Caballero & Pierre Yared, 2008. "Future Rent-Seeking and Current Public Savings," NBER Working Papers 14417, National Bureau of Economic Research, Inc.
  8. Alessandro Lizzeri, 1999. "Budget Deficits and Redistributive Politics," Review of Economic Studies, Oxford University Press, vol. 66(4), pages 909-928.
  9. Kocherlakota, Narayana R., 1996. "Reconsideration-Proofness: A Refinement for Infinite Horizon Time Inconsistency," Games and Economic Behavior, Elsevier, vol. 15(1), pages 33-54, July.
  10. Marina Azzimonti, 2011. "Barriers to Investment in Polarized Societies," American Economic Review, American Economic Association, vol. 101(5), pages 2182-2204, August.
  11. Alberto Alesina & Guido Tabellini, 1990. "A Positive Theory of Fiscal Deficits and Government Debt," Review of Economic Studies, Oxford University Press, vol. 57(3), pages 403-414.
  12. Manuel Amador & Ivan Werning & George-Marios Angeletos, 2003. "Commitment Vs. Flexibility," NBER Working Papers 10151, National Bureau of Economic Research, Inc.
  13. Thomas, Jonathan & Worrall, Tim, 1990. "Income fluctuation and asymmetric information: An example of a repeated principal-agent problem," Journal of Economic Theory, Elsevier, vol. 51(2), pages 367-390, August.
  14. Marek Kapicka, 2013. "Efficient Allocations in Dynamic Private Information Economies with Persistent Shocks: A First-Order Approach," Review of Economic Studies, Oxford University Press, vol. 80(3), pages 1027-1054.
  15. Marina, Azzimonti & Marco, Battaglini & Stephen, Coate, 2010. "On the Case for a Balanced Budget Amendment to the U.S. Constitution," MPRA Paper 25935, University Library of Munich, Germany.
  16. Mikhail Golosov & Aleh Tsyvinski, 2006. "Designing Optimal Disability Insurance: A Case for Asset Testing," Journal of Political Economy, University of Chicago Press, vol. 114(2), pages 257-279, April.
  17. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  18. repec:fth:starer:8415 is not listed on IDEAS
  19. Gary Chamberlain & Charles A. Wilson, 2000. "Optimal Intertemporal Consumption Under Uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(3), pages 365-395, July.
  20. Marina Halac, 2012. "Relational Contracts and the Value of Relationships," American Economic Review, American Economic Association, vol. 102(2), pages 750-79, April.
  21. Laibson, David I., 1997. "Golden Eggs and Hyperbolic Discounting," Scholarly Articles 4481499, Harvard University Department of Economics.
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