Compared to the increasing empirical contributions looking at the macroeconomic effects of fiscal rules (FR), the theoretical literature remains remarkably scarce. In this paper we build a theoretical model to account for the effect of fiscal rules.
Data / Methods:
We develop an endogenous growth continuous-time theoretical model. To this end, we introduce budget rules into an otherwise standard endogenous growth model. The presence of sustained economic growth makes it possible to analyze the effect of deficits in the long-run. As such, compared to the related literature devoted to long-term macroeconomic instability that restricts to a balanced budget rule (BBR), we can analyze the impact of a much wider class of budget rules, and in particular of deficit fiscal rules.
Results / Expected Results:
Focusing on the most popular FR, namely deficit fiscal rules (DFR), we first show that fixed DFR provide a well determined equilibrium. However, this is no longer the case for flexible DFR: counter-cyclical deficit rules make the equilibrium indeterminate. Then, we show that a way to restore equilibrium determinacy is to introduce in this flexible rule some inertia in deficits. In this case, however, determinacy arises only when public spending adjusts, or if the degree of inertia is high enough when taxes adjust.
Policy Implications:
Our findings provide valuable first-order insights into the design and implementation of flexible FR, all the more that, according to our calibration exercise, compared to fixed DFR, well-designed DFR may, in some cases, increase intertemporal welfare in the presence of fiscal shocks.