What Should Fiscal Councils Do?

N/AFiscal policy Council; Fiscal policy; Government policy;

Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities

We examine the impact of different degrees of fiscal feedback on debt in an economy with nominal rigidities where monetary policy is optimal. We look at the extent to which different degrees of fiscal feedback enhances or detracts from the ability of the monetary authorities to stabilise output and inflation. Using an objective function derived from utility, we find the optimal level of fiscal feedback to be small. There is a clear discontinuity in the behaviour of monetary policy and welfare either side of this optimal level. As the extent of fiscal feedback increases, optimal monetary policy becomes less active because fiscal feedback tends to deflate inflationary shocks. However this fiscal stabilisation is less efficient than monetary policy, and so welfare declines. In contrast, if fiscal feedback falls below some critical value, either the model becomes indeterminate, or optimal monetary policy becomes strongly passive, and this passive monetary policy leads to a sharp deterioration in welfare.Fiscal Policy, Feedback Rules, Debt, Macroeconomic Stabilisation

Fiscal Sustainability in a New Keynesian Model

There has been a wealth of recent work deriving optimal monetary policy utilising New Neo-Classical Synthesis (NNCS) models based on nominal inertia. Such models typically abstract from the impact of monetary policy on the government’s finances, by assuming that consumers are infinitely-lived and taxes are lump-sum such that Ricardian Equivalence holds. In this paper, in the context of a sticky-price NNCS model, we assume that the government must adjust spending and/or distortionary taxation to satisfy its intertemporal budget constraint. We then consider optimal monetary and fiscal policies under discretion and commitment in the face of technology, preference and cost-push shocks. We find that the optimal precommitment policy implies a random walk in the steady-state level of debt, generalising earlier results that involved only a single fiscal instrument. In the case of negative fiscal shocks this implies permanently higher taxation and lower output and government spending to support the new steady-state debt stock, but the optimal combination of these variables will ensure a zero rate of inflation under commitment. We also find that the time-inconsistency in the optimal precommitment policy is such that governments are tempted, given inflationary expectations, to raise taxation to reduce the ultimate debt burden they need to service. Since taxation is a distortionary labour income tax, this aggressive raising of taxation raises firms’ marginal costs and fuels inflation. We show that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original, first-best, debt level. This implies that under discretionary policy the random walk result is overturned: debt will always be returned to this initial steady-state even although there is no explicit debt target in the government’s objective function. In a series of numerical simulations we show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy.

Electoral uncertainty and the deficit bias in a New Keynesian Economy

Recent attempts to incorporate optimal fiscal policy into New Keynesian models subject to nominal inertia, have tended to assume that policy makers are benevolent and have access to a commitment technology. A separate literature, on the New Political Economy, has focused on real economies where there is strategic use of policy instruments in a world of political conflict. In this paper we combine these literatures and assume that policy is set in a New Keynesian economy by one of two policy makers facing electoral uncertainty (in terms of infrequent elections and an endogenous voting mechanism). The policy makers generally share the social welfare function, but differ in their preferences over fiscal expenditure (in its size and/or composition). Given the environment, policy shall be realistically constrained to be time-consistent. In a sticky-price economy, such heterogeneity gives rise to the possibility of one policy maker utilising (nominal) debt strategically to tie the hands of the other party, and influence the outcome of any future elections. This can give rise to a deficit bias, implying a sub-optimally high level of steady-state debt, and can also imply a sub-optimal response to shocks. The steady-state distortions and inflation bias this generates, combined with the volatility induced by the electoral cycle in a sticky-price environment, can significantly raise the costs of having a less thankfully benevolent policy maker.New Keynesian Model; Government Debt; Monetary Policy; Fiscal Policy, Electoral Uncertainty, Time Consistency.

Fiscal Policy as a Stabilisation Device for an Open Economy Inside or Outside EMU

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 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 impact of technology and mark-up shocks can be completely eliminated, 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 contrast, having government spending as an instrument contributes very little. In the case of mark-up shocks tax instruments which can offset the impact of the shock directly are highly effective, while other fiscal instruments are less useful. 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 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.

The Costs of Fiscal Inflexibility - Extended

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 under flexible exchange rates or as a (small) member of a monetary union. In a small open economy when all three fiscal instruments are freely available, we show analytically that the impact of technology and mark-up shocks can be completely eliminated, 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) are sales taxes. In contrast, having government spending as an instrument contributes very little. In the case of mark-up shocks tax instruments which can offset the impact of the shock directly are highly effective, while other fiscal instruments are less useful. 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. Second, government spending is potentially useful as a stabilisation device, because it can act as a partial substitute for monetary policy. Finally, income taxes are helpful in reducing the cost of a technology shock, although sales taxes remain the most effective instrument. 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 implementation lags in the use of fiscal instruments and, secondly, introducing government debt, such that policy makers take account of the debt consequences of using fiscal instruments as stabilisation devices. We find that implementation lags can reduce, but not eliminate, the gains from fiscal stabilisation, while the need for debt sustainability has limited impact on the use of fiscal instruments for stabilisation purposes, particularly under commitment..

Electoral Uncertainty and the Deficit Bias in a New Keynesian Economy

Recent attempts to incorporate optimal fiscal policy into New Keynesian models subject to nominal inertia, have tended to assume that policy makers are benevolent and have access to a commitment technology. A separate literature, on the New Political Economy, has focused on real economies where there is strategic use of policy instruments in a world of political conflict. In this paper we combine these literatures and assume that policy is set in a New Keynesian economy by one of two policy makers facing electoral uncertainty (in terms of infrequent elections and an endogenous voting mechanism). The policy makers generally share the social welfare function, but differ in their preferences over fiscal expenditure (in its size and/or composition). Given the environment, policy shall be realistically constrained to be time-consistent. In a sticky-price economy, such heterogeneity gives rise to the possibility of one policy maker utilising (nominal) debt strategically to tie the hands of the other party, and influence the outcome of any future elections. This can give rise to a deficit bias, implying a sub-optimally high level of steady-state debt, and can also imply a suboptimal response to shocks. The steady-state distortions and inflation bias this generates, combined with the volatility induced by the electoral cycle in a stickyprice environment, can significantly raise the costs of having a less than fully benevolent policy maker.

What Should Fiscal Councils Do?

The paper analyses theoretically what role fiscal councils could play and surveys empirically the activities of existing councils. Case studies of the Swedish Fiscal Policy Council and the UK Office for Budget Responsibility are done. It is concluded that fiscal councils should be advisory, rather than decision-making, and work as complements, rather than substitutes, to fiscal rules. A key issue is the political fragility of fiscal councils and how their long-run viability should be secured. Three ways of guaranteeing their independence are suggested: (1) reputation-building; (2)formal national rules; and (3) international monitoring.deficit bias, fiscal rules, fiscal councils

Fiscal Stabilisation Policy and Fiscal Institutions

In this paper we analyse countercyclical fiscal policy within the context of a microfounded analysis of business cycle stabilisation. We show that tax and spending instruments can have a useful counter cyclical role, even after allowing for the distortionary nature of the instruments and the need for debt sustainability. A critical barrier to the use of fiscal instruments may be political economy concerns, and we survey recent suggestions involving alternative fiscal policy institutions.

The Optimal Monetary Policy Response to Exchange Rate Misalignments

A common feature of exchange rate misalignments is that they produce a divergence between traded and non-traded goods sectors, which appears to pose a dilemma for policy makers. In this paper we develop a small open economy model which features traded and non-traded goods sectors with which to assess the extent to which monetary policy should respond to exchange rate misalignments. To do so we initially contrast the efficient outcome of the model with that under flexible prices and find that the flex price equilibrium exhibits an excessive exchange rate appreciation in the face of a positive UIP shock. By introducing sticky prices in both sectors we provide a role for policy in the face of UIP shocks. We then derive a quadratic approximation to welfare which comprises quadratic terms in the output gaps in both sectors as well as sectoral rates of inflation. These can be rewritten in terms of the usual aggregate variables, but only after including terms in relative sectoral prices and/or the terms of trade to capture the sectoral composition of aggregates. We derive optimal policy analytically before giving numerical examples of the optimal response to UIP shocks. Finally, we contrast the optimal policy with a number of alternative policy stances and assess the robustness of results to changes in model parameters.