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Risk Assessment Under a Non-linear Fiscal Rule

Listed author(s):
  • Christos Shiamptanis

    ()

    (Department of Economics, Ryerson University, Toronto, Canada)

In the aftermath of the recent financial crisis and recession, governments' actions around the world suggest a non-linear responsiveness of fiscal policy to debt. Additionally, governments are realizing that they face fiscal limits on the size of debt that they can repay. The fiscal limits arise due to distortionary taxation and political will. This paper explores the implications of a non-linear fiscal rule coupled with fiscal limits on solvency crisis. We derive the restrictions on the non-linear fiscal rule necessary to eliminate explosive behavior. We show that the marginal response of primary surplus to debt should be larger than the interest rate times an adjustment factor for the persistence in the primary surplus. However, a non-linear fiscal rule which eliminates explosive behavior can still experience a solvency crisis because of stochastic shocks. We derive the dynamics in the run-up to a solvency crisis and find that a non-linear fiscal rule can reduce the probability of solvency crisis.

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File URL: http://economics.ryerson.ca/workingpapers/wp038.pdf
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Paper provided by Ryerson University, Department of Economics in its series Working Papers with number 038.

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Length: 44 pages
Date of creation: Nov 2012
Handle: RePEc:rye:wpaper:wp038
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  1. Atish R. Ghosh & Jun I. Kim & Enrique G. Mendoza & Jonathan D. Ostry & Mahvash S. Qureshi, 2011. "Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies," NBER Working Papers 16782, National Bureau of Economic Research, Inc.
  2. Bi, Huixin, 2012. "Sovereign default risk premia, fiscal limits, and fiscal policy," European Economic Review, Elsevier, vol. 56(3), pages 389-410.
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  4. Enrique G. Mendoza & Jonathan David Ostry, 2007. "International Evidenceon Fiscal Solvency; Is Fiscal Policy "Responsible"?," IMF Working Papers 07/56, .
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  7. Daniel, Betty C. & Shiamptanis, Christos, 2012. "Fiscal risk in a monetary union," European Economic Review, Elsevier, vol. 56(6), pages 1289-1309.
  8. Hess Chung & Troy Davig & Eric Leeper, 2004. "Monetary and Fiscal Policy Switching," Econometric Society 2004 North American Summer Meetings 274, Econometric Society.
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  12. Davig, Troy & Leeper, Eric M. & Walker, Todd B., 2010. ""Unfunded liabilities" and uncertain fiscal financing," Journal of Monetary Economics, Elsevier, vol. 57(5), pages 600-619, July.
  13. James D. Hamilton & Marjorie A. Flavin, 1985. "On the Limitations of Government Borrowing: A Framework for Empirical Testing," NBER Working Papers 1632, National Bureau of Economic Research, Inc.
  14. Daniel, Betty C., 2001. "The fiscal theory of the price level in an open economy," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 293-308, October.
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  16. Todd Walker & Eric Leeper & Troy Davig, 2010. "Inflation and the Fiscal Limit," 2010 Meeting Papers 837, Society for Economic Dynamics.
  17. Betty C. Daniel & Christos Shiamptanis, 2009. "Fiscal Policy in the European Monetary Union," Working Papers 2009-1, Central Bank of Cyprus.
  18. Vanessa Berenguer‐Rico & Josep Lluís Carrion‐i‐Silvestre, 2011. "Regime shifts in stock–flow I(2)–I(1) systems: the case of US fiscal sustainability," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 26(2), pages 298-321, March.
  19. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
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