Fiscal Rules and Discretion under Persistent Shocks

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 flexibility 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 fiscal 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.

Issue Date:
Nov 09 2012
Publication Type:
Working or Discussion Paper
DOI and Other Identifiers:
Record Identifier:
Total Pages:
JEL Codes:
D02; D82; E06; H01; P16
Series Statement:
WERP 1014

 Record created 2018-04-03, last modified 2020-10-28

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