IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this paper

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

Listed author(s):
  • Joao L.M. Amador

    (Universidade Nova de Lisboa)

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: no

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2000 with number 27.

in new window

Date of creation: 05 Jul 2000
Handle: RePEc:sce:scecf0:27
Contact details of provider: Postal:
CEF 2000, Departament d'Economia i Empresa, Universitat Pompeu Fabra, Ramon Trias Fargas, 25,27, 08005, Barcelona, Spain

Fax: +34 93 542 17 46
Web page:

More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

in new window

  1. Stephen J. Turnovsky, 1997. "International Macroeconomic Dynamics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201119, January.
  2. Kenen,Peter B., 1995. "Economic and Monetary Union in Europe," Cambridge Books, Cambridge University Press, number 9780521558839, November.
  3. Perotti, Roberto & Strauch, Rolf & von Hagen, Jürgen, 1997. "Sustainability of Public Finances," CEPR Discussion Papers 1781, C.E.P.R. Discussion Papers.
  4. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  5. Barro, Robert J, 1989. "The Ricardian Approach to Budget Deficits," Journal of Economic Perspectives, American Economic Association, vol. 3(2), pages 37-54, Spring.
  6. Alesina, Alberto & Perotti, Roberto, 1996. "Fiscal Discipline and the Budget Process," American Economic Review, American Economic Association, vol. 86(2), pages 401-407, May.
  7. Bohn, Henning, 1995. "The Sustainability of Budget Deficits in a Stochastic Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(1), pages 257-271, February.
  8. Emerson, Michael & Gros, Daniel & Italianer, Alexander & ,, 1992. "One Market, One Money: An Evaluation of the Potential Benefits and Costs of Forming an Economic and Monetary Union," OUP Catalogue, Oxford University Press, number 9780198773245.
  9. Poterba, James M, 1996. "Budget Institutions and Fiscal Policy in the U.S. States," American Economic Review, American Economic Association, vol. 86(2), pages 395-400, May.
  10. Francesco Mongelli, 1999. "The Effects of the European Economic and Monetary Union (EMU) on National Fiscal Sustainability," Open Economies Review, Springer, vol. 10(1), pages 31-61, February.
  11. Nielsen, Soren Bo, 1992. "A note on the sustainability of primary budget deficits," Journal of Macroeconomics, Elsevier, vol. 14(4), pages 745-754.
  12. Alberto Alesina & Roberto Perotti, 1994. "The Political Economy of Budget Deficits," NBER Working Papers 4637, National Bureau of Economic Research, Inc.
  13. Corsetti, Giancarlo, 1997. "A portfolio approach to endogenous growth: equilibrium and optimal policy," Journal of Economic Dynamics and Control, Elsevier, vol. 21(10), pages 1627-1644, August.
  14. Eichengreen, Barry, 1993. "European Monetary Unification," Journal of Economic Literature, American Economic Association, vol. 31(3), pages 1321-1357, September.
  15. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 223-247, April.
  16. Olivier Jean Blanchard & Stanley Fischer, 1989. "Lectures on Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262022834, January.
  17. Bernheim, B Douglas, 1989. "A Neoclassical Perspective on Budget Deficits," Journal of Economic Perspectives, American Economic Association, vol. 3(2), pages 55-72, Spring.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:sce:scecf0:27. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.