Uncertainty and the preferred instrument for fiscal discipline under multitier government

This paper assesses the impact of budgetary uncertainty on the optimum instrument for fiscal discipline. In addition to exogenous uncertainty, with respect to both the savings and damages of the public deficit, the model accommodates for externalities as a result of a multitier government structure. Hence, the model approximates fiscal discipline measures within federations and especially within a monetary union. Alternative to the frequently proposed fiscal rule constraining the magnitude of the public deficit, the paper sets forth a price control (i.e. a penalty) as a policy instrument. The preferred instrument for fiscal discipline is found to be dependent on the slopes of the marginal savings and damage curves, the savings uncertainty and the correlation between uncertainty in savings and damage as well as between member states' savings shocks. In particular, strongly asymmetric shocks to budgetary policy run a borrowing constraint undesirable. The latter is stressed as exceptionally disturbing as EMU member states are still considered to be asymmetric in their stochastics, while stressing borrowing constraints as the principal instrument for fiscal discipline.