Fiscal Policy and Budget Deficit Stability in a Continuous Time Stochastic Economy

Abstract

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.

The Stability and Growth Pact: A European Answer to the Political Budget Cycle?

“…This group includes Nielsen, Bohn, Perotti, Strauch et al, or Mongelli (Bohn, 1995, Mongelli, 1999, Nielsen, 1992, Perotti, et al, 1998. In 1999, Amador emphasized the role of fiscal policy and the behavior of the budget deficit and the public debt over time (Amador, 1999). An important feature of this model was in the definition of sources of uncertainty as stochastic processes.…”

Optimal Budget Deficit Rules

“…As explained in Amador (1999), the stationary equilibrium budget deficit is smaller in the economy that follows a less rigorous fiscal policy. As a matter of fact, the stationary equilibrium budget deficit must be smaller in order to allow for a slower rate of public debt accumulation.…”

“…First, we compare two economies with different intervention costs. Then, we make use of a previously developed continuous time stochastic model (Amador, 1999) to examine the effects of public expenditure and taxation on the optimal budget deficit rules. Finally, the same thing is carried out for changes in the variance of technology and public expenditure shocks.…”

“…Thus, there is scope for integration between the two literatures. In our paper, the characteristics of the stochastic process that rules the path of the budget deficit are taken from a previously developed continuous time stochastic model (see Amador, 1999). Due to this, it is possible to establish some relationships between the structural parameters of the economy and the optimal budget deficit rules.…”

“…This paper is also an example of integration between stochastic process optimal control methods and the continuous time stochastic models. In fact, the characteristics of the stochastic process that rules the path of the budget deficit are taken from a previously developed continuous time stochastic model (Amador, 1999). Finally, simulation methods are used in order to conduct a comparative dynamics analysis.…”