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How to Starve the Beast: Fiscal and Monetary Policy Rules

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  • Fernando Martin

    (Federal Reserve Bank of St. Louis)

Abstract

Societies have come to rely on simple rules to restrict the size and behavior of governments: constraints on monetary policy, revenue, budget balance and debt. I study the merit of these constraints in a dynamic stochastic model in which fiscal and monetary policies are jointly determined. Under several specifications, a revenue ceiling is the only rule that effectively induces the government to lower spending and dominates other policy constraints in terms of welfare by an order of magnitude. However, the reduction in spending is modest and comes at the cost of higher debt and inflation. Monetary policy rules are not desirable as they severely hinder distortion-smoothing and may lead to large welfare losses if implemented incorrectly. Budget balance and debt rules are generally benign, with the former being always preferable to the latter. All types of fiscal rules are usually best implemented at all times, but can be suspended in adverse times, often at a minor cost.

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  • Fernando Martin, 2019. "How to Starve the Beast: Fiscal and Monetary Policy Rules," 2019 Meeting Papers 1181, Society for Economic Dynamics.
  • Handle: RePEc:red:sed019:1181
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    References listed on IDEAS

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    1. Stöhlker, Daniel & Neumeier, Florian & Fuest, Clemens, 2018. "Tax Cuts Starve the Beast! Evidence from Germany," VfS Annual Conference 2018 (Freiburg, Breisgau): Digital Economy 181592, Verein für Socialpolitik / German Economic Association.
    2. Martin, Fernando M., 2015. "Debt, inflation and central bank independence," European Economic Review, Elsevier, vol. 79(C), pages 129-150.
    3. 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.
    4. Robert J. Barro & David B. Gordon, 2019. "A Positive Theory of Monetary Policy in a Natural Rate Model," Credit and Capital Markets, Credit and Capital Markets, vol. 52(4), pages 505-525.
    5. Fernando Martin, 2009. "A Positive Theory of Government Debt," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 608-631, October.
    6. Martin, Fernando M., 2011. "On the joint determination of fiscal and monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(2), pages 132-145, March.
    7. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
    8. Fernando M. Martin, 2013. "Government Policy In Monetary Economies," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 54(1), pages 185-217, February.
    9. Williamson, Stephen & Wright, Randall, 2010. "New Monetarist Economics: Models," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.),Handbook of Monetary Economics, edition 1, volume 3, chapter 2, pages 25-96, Elsevier.
    10. Martin Fernando M., 2012. "Government Policy Response to War-Expenditure Shocks," The B.E. Journal of Macroeconomics, De Gruyter, vol. 12(1), pages 1-40, July.
    11. Fernando M. Martin & Christopher J. Waller, 2012. "Sovereign debt: a modern Greek tragedy," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 321-340.
    12. Martin, Fernando M., 2010. "Markov-perfect capital and labor taxes," Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 503-521, March.
    13. James Cloyne, 2013. "Discretionary Tax Changes and the Macroeconomy: New Narrative Evidence from the United Kingdom," American Economic Review, American Economic Association, vol. 103(4), pages 1507-1528, June.
    14. Nina T Budina & Andrea Schaechter & Anke Weber & Tidiane Kinda, 2012. "Fiscal Rules in Response to the Crisis; Toward the "Next-Generation" Rules: A New Dataset," IMF Working Papers 12/187, International Monetary Fund.
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