A New Design for Automatic Fiscal Policy

Abstract

We offer a new design for automatic fiscal policy that can strengthen its role as a complement to counter-cyclical monetary policy, and analyse it in the Fair macroeconometric model that has been estimated using quarterly data for the US economy. Our automatic fiscal policy consists of the triggering of a transfer (or income tax rebate) whenever real GDP is at least X% below normal, the amount of the transfer varying with the size of the GDP gap. The size of the transfer is set with the sole purpose of effectively combating a recession. By contrast, the magnitudes of current automatic stabilizers are unintended by-products of setting the ratio of tax revenue to GDP, the degree of progressivity of the tax system and the level of unemployment benefits. We generate a severe recession using historical data and simulate the impact of our automatic fiscal policy. We assume that the Federal Reserve adheres to a counter-cyclical monetary policy governed by the interest rate (Taylor) rule estimated from historical data. We find that the interest rate rule alone mitigates the severe recession only modestly, whereas our automatic fiscal policy (together with the interest rate rule) substantially reduces the severity of the recession while generating only a relatively small rise in the government debt/GDP ratio.

Macroeconomic Stabilization through an Employer of Last Resort

“…Laurence Klein's (1991) frequentlycited, standard text on comparative macroeconometric models presents Fairmodel simulations alongside models used by the Federal Reserve, the University of Michigan, the Bureau of Economic Analysis, DRI, and WEFA. More recently, Seidman and Lewis (2002) and Seidman (2003) make extensive use of the Fairmodel for simulations of alternative macroeconomic policies. Both also show that the Fairmodel's structural approach to modeling consumer behavior is more consistent with generally accepted empirical evidence than the intertemporal consumption smoothing approach prevalent in modern macroeconomic theory.…”

“…Seidman and Lewis (2002) propose an asymmetric fiscal policy rule which triggers transfer payments "in response to a decline in the output of the economy of particular magnitude" (262). The policy rule is asymmetric because it "does not attempt to restrain demand when demand is excessive.…”

Designing Macroeconomic Frameworks: A Positive Analysis of Monetary and Fiscal Delegation*

“…Indeed, growing empirical evidence consistently shows that the macroeconomic stabilization function of fiscal policy is embedded in automatic stabilizers, not discretionary impulses (e.g. Seidman and Lewis 2002;Fatàs and Mihov 2003). 6 Although previous studies mentioned related arguments in different models, they never formally developed the idea (Nordhaus 1994;Agell et al 1996;Levine and Pearlman 1998;Pina 1999;Dixit 2001).…”

Fiscal Delegation in a Monetary Union with Decentralized Public Spending

“…Likewise, an independent authority with a mandate for low debt or low deficits might successfully combat deficit bias, as long as it controls instruments of sufficient power to make debt control feasible. While this possibility has not featured prominently in the current Eurozone debate, frameworks like this have been proposed for many countries and regions, including Australia and New Zealand (Ball (1996), Gruen (1997)); the US (Blinder (1997), Seidman and Lewis (2002)); Latin America (Eichengreen, Hausmann, and von Hagen (1999)); and the European Union (von Hagen and Harden (1995); Wren-Lewis (2002); Wren-Lewis (2011);…”