Scientific Monographs, Bank of Finland
No E:33/2006:
Essays on macroeconomic effects of fiscal policy rules
Jukka Railavo ()
Abstract: Economic and Monetary Union (EMU) can be characterised as
a complicated set of legislation and institutions governing monetary and
fiscal responsibilities. The measures of fiscal responsibility are to be
guided by the Stability and Growth Pact (SGP), which sets rules for fiscal
policy and makes a discretionary fiscal policy virtually impossible. To
analyse the effects of the fiscal and monetary policy mix, we modified the
New Keynesian framework to allow for supply effects of fiscal policy. We
show that defining a supply-side channel for fiscal policy using an
endogenous output gap changes the stabilising properties of monetary policy
rules. The stability conditions are affected by fiscal policy, so that the
dichotomy between active (passive) monetary policy and passive (active)
fiscal policy as stabilising regimes does not hold, and it is possible to
have an active monetary — active fiscal policy regime consistent with
stability of the economy. We show that, if we take supply-side effects into
account, we get more persistent inflation and output reactions. We also
show that the dichotomy does not hold for a variety of different fiscal
policy rules based on government debt and budget deficit, using the tax
smoothing hypothesis and formulating the tax rules as difference equations.
The debt rule with active monetary policy results in indeterminacy, while
the deficit rule produces a determinate solution with active monetary
policy, even with active fiscal policy. The combination of fiscal
requirements in a rule results in cyclical responses to shocks. The
amplitude of the cycle is larger with more weight on debt than on deficit.
Combining optimised monetary policy with fiscal policy rules means that,
under a discretionary monetary policy, the fiscal policy regime affects the
size of the inflation bias. We also show that commitment to an optimal
monetary policy not only corrects the inflation bias but also increases the
persistence of output reactions. With fiscal policy rules based on the
deficit we can retain the tax smoothing hypothesis also in a sticky price
model.
Keywords: inflation; fiscal policy; fiscal policy rules; optimal monetary policy; policy coordination; stabilisation; (follow links to similar papers)
JEL-Codes: E31; E52; E61; E63; (follow links to similar papers)
156 pages, January 1, 2006
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