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Fiscal Rules and Discretion under Persistent Shocks

Author

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  • Halac, Marina

    (Department of Economics, University of Warwick)

  • Yared, Pierre

    (Columbia University and NBER)

Abstract

This paper studies the optimal level of discretion in policymaking. We consider a fiscal policy model where the government has time-inconsistent preferences with a present-bias towards public spending. The government chooses a fiscal rule to trade off its desire to commit to not overspend against its desire to have exibility to react to privately observed shocks to the value of spending. We analyze the optimal fiscal rule when the shocks are persistent. Unlike under i.i.d: shocks, we show that the ex-ante optimal rule is not sequentially optimal, as it provides dynamic incentives. The ex-ante optimal rule exhibits history dependence, with high shocks leading to an erosion of future scal discipline compared to low shocks, which lead to the reinstatement of discipline. The implied policy distortions oscillate over time given a sequence of high shocks, and can force the government to accumulate maximal debt and become immiserated in the long run. JEL classification: Institutions ; Asymmetric and Private Information ; Macroeconomic Polic ; Structure of Government ; Political Economy JEL codes: D02 ; D82 ; E6 ; H1 ; P16

Suggested Citation

  • Halac, Marina & Yared, Pierre, 2013. "Fiscal Rules and Discretion under Persistent Shocks," The Warwick Economics Research Paper Series (TWERPS) 1014, University of Warwick, Department of Economics.
    • Handle: RePEc:wrk:warwec:1014
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D02 - Microeconomics - - General - - - Institutions: Design, Formation, Operations, and Impact
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • H1 - Public Economics - - Structure and Scope of Government
    • P16 - Political Economy and Comparative Economic Systems - - Capitalist Economies - - - Capitalist Institutions; Welfare State

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