"Fiscal Rules and Discretion under Persistent Shocks"
Publication type: Working paper
This paper studies the optimal level of discretion in policymaking. We consider a dynamic fiscal policy model in which the government has time-inconsistent preferences with a present-bias towards 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 allow the shocks to be persistent over time, and analyze the optimal structure of fiscal rules in this mechanism design problem. If shocks are i.i.d., the ex-ante optimal rule, chosen at the beginning of time, coincides with the sequentially optimal rule, chosen period by period. We show that when shocks are persistent, the ex-ante optimal rule is no longer sequentially optimal, as dynamic incentives are now provided. Furthermore, under persistent shocks, 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 fiscal discipline. In contrast, the sequentially optimal rule is independent of history, and takes the simple form of a state-dependent debt limit.
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