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Fiscal Rules and Discretion under Persistent Shocks

  • Halac, Marina

    (Department of Economics, University of Warwick)

  • Yared, Pierre

    (Columbia University and NBER)

This paper studies the optimal level of discretion in policymaking. We consider a fiscal policy model where the government has time-inconsistent preferences with a present-bias towards public spending. The government chooses a fiscal rule to trade off its desire to commit to not overspend against its desire to have exibility to react to privately observed shocks to the value of spending. We analyze the optimal fiscal rule when the shocks are persistent. Unlike under i.i.d: shocks, we show that the ex-ante optimal rule is not sequentially optimal, as it provides dynamic incentives. The ex-ante optimal rule exhibits history dependence, with high shocks leading to an erosion of future scal discipline compared to low shocks, which lead to the reinstatement of discipline. The implied policy distortions oscillate over time given a sequence of high shocks, and can force the government to accumulate maximal debt and become immiserated in the long run. JEL classification: D02 ; D82 ; E6 ; H1 ; P16

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File URL: http://www2.warwick.ac.uk/fac/soc/economics/research/workingpapers/2013/twerp_1014_halac.pdf
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Paper provided by University of Warwick, Department of Economics in its series The Warwick Economics Research Paper Series (TWERPS) with number 1014.

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Date of creation: 2013
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Handle: RePEc:wrk:warwec:1014
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  1. Lizzeri, Alessandro, 1999. "Budget Deficits and Redistributive Politics," Review of Economic Studies, Wiley Blackwell, vol. 66(4), pages 909-28, October.
  2. Marina Halac, 2012. "Relational Contracts and the Value of Relationships," American Economic Review, American Economic Association, vol. 102(2), pages 750-79, April.
  3. marina, azzimonti, 2009. "Barriers to investment in polarized societies," MPRA Paper 25936, University Library of Munich, Germany.
  4. Laibson, David I., 1997. "Golden Eggs and Hyperbolic Discounting," Scholarly Articles 4481499, Harvard University Department of Economics.
  5. Bruno Strulovici, 2011. "Renegotiation-Proof Contracts with Moral Hazard and Persistent Private Information," Discussion Papers 1519, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  6. Mikhail Golosov & Aleh Tsyvinski, 2006. "Designing Optimal Disability Insurance: A Case for Asset Testing," Journal of Political Economy, University of Chicago Press, vol. 114(2), pages 257-279, April.
  7. Stephen Coate & Marco Battaglini, 2007. "A Dynamic Theory of Public Spending, Taxation and Debt," 2007 Meeting Papers 573, Society for Economic Dynamics.
  8. Marco Battaglini, 2009. "On the Case for a Balanced Budget Amendment to the U.S. Constitution," 2009 Meeting Papers 131, Society for Economic Dynamics.
  9. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  10. Gary Chamberlain & Charles A. Wilson, 2000. "Optimal Intertemporal Consumption Under Uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(3), pages 365-395, July.
  11. Tabellini, Guido & Alesina, Alberto, 1990. "A Positive Theory of Fiscal Deficits and Government Debt," Scholarly Articles 3612769, Harvard University Department of Economics.
  12. Kocherlakota, Narayana R., 1996. "Reconsideration-Proofness: A Refinement for Infinite Horizon Time Inconsistency," Games and Economic Behavior, Elsevier, vol. 15(1), pages 33-54, July.
  13. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  14. Christopher Sleet, 2004. "Optimal Taxation with Private Government Information," Review of Economic Studies, Oxford University Press, vol. 71(4), pages 1217-1239.
  15. Caballero, Ricardo J. & Yared, Pierre, 2010. "Future rent-seeking and current public savings," Journal of International Economics, Elsevier, vol. 82(2), pages 124-136, November.
  16. Thomas, Jonathan & Worrall, Tim, 1990. "Income fluctuation and asymmetric information: An example of a repeated principal-agent problem," Journal of Economic Theory, Elsevier, vol. 51(2), pages 367-390, August.
  17. Pierre Yared, 2010. "Politicians, Taxes and Debt," Review of Economic Studies, Oxford University Press, vol. 77(2), pages 806-840.
  18. Manuel Amador & George-Marios Angeletos & Ivan Werning, 2004. "Commitment vs. Flexibility," 2004 Meeting Papers 87, Society for Economic Dynamics.
  19. Christopher Sleet, 2004. "Optimal Taxation with Private Government Information," Review of Economic Studies, Wiley Blackwell, vol. 71(4), pages 1217-1239, October.
  20. Alberto Alesina & Roberto Perotti, 1994. "The Political Economy of Budget Deficits," NBER Working Papers 4637, National Bureau of Economic Research, Inc.
  21. Marek Kapicka, 2013. "Efficient Allocations in Dynamic Private Information Economies with Persistent Shocks: A First-Order Approach," Review of Economic Studies, Oxford University Press, vol. 80(3), pages 1027-1054.
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