HT - 07. Fiscal Policy

Question 1

Seminal Papers (4)

Answer 1

Determinacy depends on both FP and MP, FP can help at ZLB

Leeper (2001),
Benigno and Woodford (2003),
Woodford (1998)
Eggertsson (2011) - FP can be expansionary / contractionary at ZLB

Question 2

Davig and Leeper (2006)

Answer 2

• time varying policy rules can widen determinacy region,

Question 3

Leeper (2001):

Answer 3

• Existence and uniqueness of equilibria depends on two policy parameters: MP and FP responsiveness

Aim: Study interactions between monetary and fiscal policy both being “active” or “passive” in their responsive to government debt shocks.

Conclusion: Matrix of determinacy depends jointly on active/passive MP and FP.

Question 4

Woodford (1995):

Answer 4

Aim: Show that price levels can still be determinate when MP is radically conducive to loss of price level control eg. Interest rate peg

Conclusion: Government budget plays a key role in price level determination, and stability of expectations around future government budgets is essential for price level stability.

Question 5

Woodford (2001):

Answer 5

Aim: Show that price stability is dependent on MP and an appropriate FP rule too.

• Ricardian equivalence does NOT –> FP irrelevant…only the “Ricardian” policies within FP

Conclusion: Optimal combination with attractive properties: MP –> Taylor Rule, FP –> Nominal deficit targeting commitment. MP is insufficient alone to determine price level, fiscal expectations inconsistent with this can block the equilibrium eg. (Sargent and Wallace, 1981)

Question 6

Benigno and Woodford (2004):

Answer 6

• Inflation determination depends on both MP and tax policy as tax rate impacts real MC and hence aggregate supply relation.

Aim: Consider two policy sides simultaneously. How do optimal MP rules change when they consider the fiscal consequences when a government can only get revenues from distortionary taxation. How does optimal tax policy adjust when we consider stickiness in price adjustments.

Conclusion:

• Sticky prices –> Output also demand determined, not just supply side.
• Variation in the level of distorting taxes should be chosen with the same objectives as MP: inflation and output gap stabilisation.
• MP should consider impact of polices on government budget. Interest rate paths matter for real burden of debt interest payments.

Question 7

Eggertsson (2011):

Answer 7

Conclusion: Labour income tax cut may be counterproductive when the ZLB binds –> It can act as a catalyst for the destructive deflationary spiral if downward pressure accumulates over time and goods expenditure is sufficiently responsive to the interest rate. However, if taxes operate in an orthodox fashion on disposable income it could be expansionary.

Question 8

Topic Summary (3)

Answer 8

• “Separation principle”: CB –> macroeconomic stabilisation & Fiscal Authority –> Gov debt sustainabilitiy
o Introduce distortionary taxes –> Sales tax becomes an endogenous FP instrument altering budget
• Policy maker would like to set inflation and output gap = 0 always –> Distortionary taxes = 0 –> Unsustainable debt!
o Optimal FP  Trades-off: Debt sustainability vs. distortionary taxation
o Flex prices –> Keep taxes constant
o Sticky prices –> Permanent changes in taxes and debt
• Fiscal policy can have a key role at the ZLB
o Tax cuts –> contractionary
o Fiscal spending –> expansionary