Fiscal Policy And Budget Deficit Stability In A Continuous Time Stochastic Economy

The study of fiscal policy and budget deficits has been an active field of research in economic theory throughout the decades. This literature has addressed very different questions such as the consequences of running budget deficits, the optimal financing of budget deficits or the required conditions to avoid an unsustainable path for the public debt. Nowadays, fiscal policy analysis has gained increased interest in the face of the new monetary union in Europe. In fact, public spending and taxation are the remaining major policy instruments available for the countries participating in the monetary union. Therefore, it is vital to know how should countries set fiscal parameters and their consequences on general macroeconomic performance. Furthermore, to run large budget deficits in a monetary union can become a serious problem. As a matter of fact, if a country cannot finance the budget deficit in each moment it will either default, creating a problem in the bond market of the monetary area, or be bailed-out by a central authority. It is known that the domestic monetarization of budget deficits is no longer an available solution in monetary unions. This type of concerns has lead to the setting of guidelines for the budget deficits and public debt in the countries that would take part in the European Monetary Union. The Maastricht treaty transformed these guidelines into pre-entry conditions, and more recently, the Stability and Growth Pact adopted them as rules for the future of the monetary union. Therefore, it is very important to characterize the stationary equilibrium path of the budget deficit. There are several studies focusing on these topics. Many of them examine the effects of fiscal policy and the budget deficits. A short and incomplete list of such studies includes Blanchard (1985), Barro (1989), Bernheim (1989), Emerson et al (1992). Other studies clearly deal with the question of the sustainability of the budget deficit. In this group we include Nielsen (1992), Bohn (1995), Perotti, Strauch and von Hagen (1998) and Mongelli (1999). The aim of this paper is to develop a general equilibrium continuous time stochastic model, stressing the role of fiscal policy and the behavior of budget deficit and public debt. An important feature of the model is the definition of the sources of uncertainty as stochastic processes and the utilization of stochastic optimization methods, such as in Turnovsky (1995) and (1997). This author presents a general framework that is wider than the one adopted here, but assumes that taxation endogenously adjusts fiscal imbalances. We reduce the number of variables in the economy and focus instead on the endogenous determination of the public bond market equilibrium, and on its effects on the budget deficit. One of the simplifying assumptions is to consider a non-monetary economy. It is true that this hypothesis limits the analysis of important features such as inflation or the monetary financing of budget deficits. However, it may not be restrictive in the case of monetary unions where the central bank follows a low inflation oriented monetary policy and refuses to bail out single countries. This is clearly the case in the European Union. Another simplifying assumption is to consider a closed economy. This limits the ability of the government to sell public bonds abroad, which has obvious consequences on the budget deficit. Despite important, we argue later that this assumption does not change the main results of the paper and allows for a clear analysis of what is behind the sustainability of budget deficits. Within this framework, we endogenously obtain an expression for the equilibrium budget deficit as a percentage of deterministic output and an expression for the public bond's equilibrium interest rate. In addition, it is possible to determine the equilibrium growth rate of the economy and the weight of capital stock and public bonds on total wealth. These results provide answers to some important questions, namely to know what are the major determinants of the equilibrium budget deficit, how to assure the sustainability of public debt, how is the growth rate of the economy affected by fiscal policy and how does uncertainty affect the results. The paper concludes that changes on the tax rate, on average public spending and on the properties of the shocks that affect the economy lead to unsustainable budget deficit behavior. These changes define structural shocks on the stationary equilibrium, which can only be compensated through additional changes in structural parameters. On the contrary, short run shocks on technology and public expenditure are part of the stationary equilibrium and consistent with budget deficit stability. In addition, it is shown that the stationary equilibrium in economies with low tax rates and high public spending must be associated with a low public debt-wealth ratio and a low budget deficit. The same is true for economies facing a high volatility on technology and expenditure shocks. The paper is divided into eight sections. In the next section we present the continuous time stochastic economy. We describe production technology as well as the problem of the representative consumer. Next, we present the optimum conditions of the problem. In the third section we introduce public expenditure and define both budget deficits and public bond market equilibrium. Then, in the fourth section, a partial equilibrium analysis is presented. In the fifth section the general equilibrium solution of the model is obtained. Then, in the sixth section, we examine how changes in fiscal policy and uncertainty parameters affect the equilibrium. Moreover, we analyze the consequences of these changes in terms of the path of the deficit. In the seventh section simulation methods are used to examine different scenarios and to plot the path of the variables in the stationary equilibrium. Finally, section eight presents some concluding remarks.