Fiscal Rules and Discretion under Persistent Shocks

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 toward 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 independent and identically distributed 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.

Dynamic Mechanism Design for a Global Commons

“…Only one-period deviations in the disclosure decisions are considered. The proof in the Appendix shows that the solution to this "super-relaxed" problem is a fully compressed quota given by equation (21). A fully compressed quota is shown to be immune from multi period deviations as well.…”

Prudent debt targets and fiscal frameworks

“…Since Kydland and Prescott's (1977) seminal contribution, it is known that time-inconsistency often prevails because short-term considerations push policymakers to deviate from ex-ante optimal strategies. Moreover, Halac and Yared (2014) show that, when shocks are persistent, the ex-ante optimal rule is not sequentially optimal, as it provides incentives for governments to over-accumulate debt. Also, fiscal rules may limit the capacity of governments to pursue macroeconomic stabilisation policies (see also Wyplosz (2013), for a discussion).…”

Government Policy with Time Inconsistent Voters

“…Amador, Werning, and Angeletos (2006) characterize the optimal budget set, balancing commitment and flexibility, for decision-makers who are susceptible to temptation and face a consumption-savings problem in which independent taste shocks are experienced over time. Halac and Yared (2014) use this setting as a spring-board to study the optimal levels of discretion in policy making. They depart from Amador, Werning, and Angeletos (2006) by allowing for persistent taste shocks and interpret decision-makers as governments with a present bias toward public spending.…”