Fiscal rules and monetary policy in a dynamic stochastic general equilibrium model

In this paper an anti-cyclical fiscal policy rule is introduced into a dynamic stochastic general equilibrium model with New-Keynesian features. The rule allows the deficit to deviate from target in proportion to the impact of automatic stabilisers while any additional impact on the deficit, for example on interest expenditure, has to be offset through adjustments of government consumption or taxes. The size of the automatic stabilisers is endogenously determined as the change in the primary deficit that is induced by economic fluctuations for a given tax system. The model is calibrated, and it is shown how the conditions for monetary policy to secure stability and determinacy of the model's equilibrium depend on the fiscal policy rule and, in particular, on the means used to fulfil the rule. It is demonstrated that the Taylor principle holds for reasonable values of the fiscal policy parameter if fiscal policy relies on changes in lump-sum taxes. This runs counter to the benchmark result of Leeper (1991). The same goes for the cases that consumption taxes, profit taxes or government consumption are adjusted to fulfil the fiscal rule. However, if the fiscal rule is met through adjustments of wage or interest tax rates, the range of values of the monetary policy parameter that ensures stability and determinacy change significantly.