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Fiscal Consolidation and the Probability Distribution of Deficits: A Stochastic Analysis of the Stability Pact

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  • A J Hughes Hallett
  • Peter McAdam

Abstract

Using stochastic simulations, this paper analyses the probability distribution of a country's deficit ratio under fixed exchange rates and a variety of monetary policy rules. The purpose is to show how the probability of getting an "excessive deficit", defined as a deficit / GDP ratio in excess of 3% by Europe's Stability Pact, varies with different deficit target rules and different fiscal and monetary policy rules. We find that these fiscal ratios typically have a wide distribution, with fat tails and significantly longer tails on the upper side. That means fiscal targets may have to be country specific and conservative, and that fiscal policy has to be forward looking to keep the probability of excessive deficits below acceptable limits.

Suggested Citation

  • A J Hughes Hallett & Peter McAdam, 2001. "Fiscal Consolidation and the Probability Distribution of Deficits: A Stochastic Analysis of the Stability Pact," Studies in Economics 0101, School of Economics, University of Kent.
    • Handle: RePEc:ukc:ukcedp:0101
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    References listed on IDEAS

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    1. Salmon, Mark H, 1982. "Error Correction Mechanisms," Economic Journal, Royal Economic Society, vol. 92(367), pages 615-629, September.
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    5. Mr. Paul R Masson & Mr. Bart Turtelboom, 1997. "Characteristics of the Euro, the Demand for Reserves, and Policy Coordination Under EMU," IMF Working Papers 1997/058, International Monetary Fund.
    6. Mitchell, Peter R. & Sault, Joanne E. & Smith, Peter N. & Wallis, Kenneth F., 1998. "Comparing global economic models," Economic Modelling, Elsevier, vol. 15(1), pages 1-48, January.
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    8. Peter McAdam & A. J. Hughes Hallett, 1999. "Nonlinearity, ComputationaL Complexity and Macroeconomic Modelling," Journal of Economic Surveys, Wiley Blackwell, vol. 13(5), pages 577-618, December.
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    More about this item

    Keywords

    Fiscal cushion; Policy Reaction Functions; Stochastic simulations; Monetary union;
    All these keywords.

    JEL classification:

    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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