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The Costs of Fiscal Inflexibility

  • Campbell Leith

    (University of Glasgow)

  • Simon Wren-lewis

    (University of Exeter)

Extending Gali and Monacelli (2004), we build an N-country open economy model, where each economy is subject to sticky wages and prices and, potentially, has access to sales and income taxes as well as government spending as fiscal instruments. We examine an economy either as a small open economy operating under flexible exchange rates or as a member of a monetary union. In a small open economy when all three fiscal instruments are freely available, we show analytically that the welfare impact of technology and mark-up shocks can be completely eliminated (in the sense that policy can replicate the efficient flex price equilibrium), whether policy acts with discretion or commitment. However, once any one of these fiscal instruments is excluded as a stabilisation tool, costs can emerge. Using simulations, we find that the useful fiscal instrument in this case (in the sense of reducing the welfare costs of the shock) is either income taxes or sales taxes. In constrast, having government spending as an instrument contributes very little. The results for an individual member of a monetary union facing an idiosyncratic technology shock (where monetary policy in the union does not respond) are very different. First, even with all fiscal instruments freely available, the technology shock will incur welfare costs. Government spending is potentially useful as a stabilisation device, because it can act as a partial substitute for monetary policy. Finally, sales taxes are more effective than income taxes at reducing the costs of a technology shock under monetary union. If all three taxes are available, they can reduce the impact of the technology shock on the union member by around a half, compared to the case where fiscal policy is not used. Finally we consider the robustness of these results to two extensions. Firstly, introducing government debt, such that policy makers take account of the debt consequences of using fiscal instruments as stabilisation devices, and, secondly, introducing implementation lags in the use of fiscal instruments. We find that the need for debt sustainability has a very limited impact on the use of fiscal instruments for stabilisation purposes, while implementation lags can reduce, but not eliminate, the gains from fiscal stabilisation.

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Paper provided by ESRC World Economy and Finance Research Programme, Birkbeck, University of London in its series WEF Working Papers with number 0005.

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Date of creation: Mar 2006
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Handle: RePEc:wef:wpaper:0005
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  1. Campbell leith & Simon Wren-Lewis, . "Compatibility Between Monetary and Fiscal Policy Under EMU," Working Papers 2001_15, Business School - Economics, University of Glasgow.
  2. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  3. Söderlind, Paul, 1998. "Solution and Estimation of RE Macromodels with Optimal Policy," SSE/EFI Working Paper Series in Economics and Finance 256, Stockholm School of Economics.
  4. Campbell leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," Working Papers 2001_16, Business School - Economics, University of Glasgow.
  5. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  6. Lombardo, Giovanni & Sutherland, Alan, 2004. "Monetary and fiscal interactions in open economies," Journal of Macroeconomics, Elsevier, vol. 26(2), pages 319-347, June.
  7. Currie,David & Levine,Paul, 2009. "Rules, Reputation and Macroeconomic Policy Coordination," Cambridge Books, Cambridge University Press, number 9780521104609.
  8. Campbell Leith & Simon Wren-Lewis, 2006. "Fiscal Sustainability in a New Keynesian Model," Working Papers 2006_11, Business School - Economics, University of Glasgow, revised Nov 2008.
  9. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
  10. Pierpaolo Benigno & Michael Woodford, 2003. "Optimal Monetary and Fiscal Policy: A Linear Quadratic Approach," NBER Working Papers 9905, National Bureau of Economic Research, Inc.
  11. Beetsma, Roel & Jensen, Henrik, 2003. "Mark-Up Fluctuations and Fiscal Policy Stabilization in a Monetary Union," CEPR Discussion Papers 4020, C.E.P.R. Discussion Papers.
  12. Martin Ellison & Neil Rankin, 2005. " Optimal Monetary Policy When Lump-Sum Taxes Are Unavailable: A Reconsideration of the Outcomes under Commitment and Discretion," CDMA Conference Paper Series 0501, Centre for Dynamic Macroeconomic Analysis.
  13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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