Fiscal rule and shock amplification : A stochastic endogenous growth model

This paper develops a discrete-time stochastic endogenous growth model to study the amplification role of fiscal rules. In our model, transitory shocks exert permanent effects on the level of variables in equilibrium (hysteresis), and can be strongly amplified by the public debt adjustment, leading to a procyclical amplification mechanism (the "public debt accelerator"). This procyclical stance depends on the speed of adjustment of the debt-to-GDP ratio under a fixed-fiscal rule. A cold turkey strategy removes the public debt shock, but at the risk of destabilizing other variables, while a gradualist strategy has a stabilization effect, with detrimental consequences in the long-run. Finally, we show that a flexible-fiscal rule helps smooth aggregate variables by limiting the cuts in productive public spending.