Fiscal policy and budget deficit stability in a continuous time stochastic economy

This paper models the role of the fiscal policy and the behaviour of the budget deficit in a continuous time stochastic economy. The model is developed in a general equilibrium framework, integrating the optimisation behaviour of representative consumer and the intertemporal resource constraint of the fiscal authority. The main features of the model are the endogenous determination of the budget deficit as a percentage of deterministic output, the endogenous determination of the public bonds interest rate and the analysis of how changes in the structural and stochastic parameters affect the stationary equilibrium. In this context, we obtain conditions for the stability of the budget deficit. Finally, the paper simulates different scenarios and plots the stationary equilibrium path of the variables. The paper concludes that changes in the structural parameters of the model lead to unsustainable budget deficit behaviour. On the contrary, short-run shocks on technology and public expenditure are consistent with the stationary equilibrium. In addition, it is shown that the stationary equilibrium in economies having low tax rates and high public spending must be associated with a low public debt-wealth ratio and a low budget deficit. The same is true for economies that face high volatility in technology and expenditure shocks.