Fiscal Rules in a Monetary Economy: Implications for Growth and Welfare

This study considers two fiscal rules, a debt rule that controls the debt-to- GDP ratio, and an expenditure rule that controls the expenditure-to-GDP ratio, in a monetary growth model with financial intermediation. Tightening fiscal rules promotes economic growth and thus benefits future generations. However, there could be two equilibria of the nominal interest rates, and the welfare effects of the rules on the current generation are different between the two equilibria. In particular, the effects of a decreased debt-to-GDP ratio depend on its initial ratio; a low (high) ratio country has an incentive (no incentive) to reduce the ratio further from the viewpoint of the current generation's welfare. This result offers a reason for difficulties with fiscal reform in countries with already high debt-to-GDP ratios.