Advanced Macroeconomics II

Fiscal Policy

Jordi Galí

Universitat Pompeu FabraApril 2019

Dimensions of Fiscal Policy

(a) Expenditures- purchases of goods and services (e.g. administration, public goods)- transfers (e.g. unemployment benefits, pensions)- subsidies (to promote certain activities)- interest expenses (on public debt)

(b) Revenues (taxes)- financing of public expenditures- discourage/punish certain activities

Difference between (a) and (b): deficit/surplus→ issuance of debt/accumulation of assets→ seignorage

Fiscal policy and economic fluctuations→ stabilization tool→ source of fluctuations

Fiscal Policy in the Basic RBC ModelGovernment budget constraint in period t:

Gt + (1 + rt−1)Bgt−1 = τntWtNt + Tt + Bg

t

Household’s budget constraint in period t:

Ct + Bt = (1− τnt )WtNt + (1 + rt−1)Bt−1 + Dt − Tt

Definitions:

Gt: public consumptionBGt : government debt

τnt : labor income taxTt: lump-sum tax (non-distorting)

Modified intratemporal optimality condition:

Un,t + (1− τnt )WtUc,t = 0

for t = 0, 1, 2, ...

Example + log-linear version:

wt = σct + ϕnt − log(1− τnt )

Equilibrium

• Goods marketYt = Ct + Gt

Log-linear version (ignoring constants):

yt = (1− sg)ct + sggt

where sg ≡ G/Y .

• Labor marketσct + ϕnt − log(1− τnt ) = at − αnt + log(1− α)

• Asset marketbt = bgt

ct = Et{ct+1} −1

σ(rt − ρ)

• Equilibrium values (ignoring constants and using log(1− τnt ) ' −τnt ):

nt =(1− sg − σ)at − (1− sg)τnt + σsggt

σ(1− α) + (1− sg)(α + ϕ)

yt =(1 + ϕ)(1− sg)at − (1− α)(1− sg)τnt + (1− α)σsggt

σ(1− α) + (1− sg)(α + ϕ)

ct =(1 + ϕ)at − (1− α)τnt − sg(α + ϕ)gt

σ(1− α) + (1− sg)(α + ϕ)

wt =[σ + ϕ(1− sg)]at + α(1− sg)τnt − ασsggt

σ(1− α) + (1− sg)(α + ϕ)

rt = ρ + σEt{∆ct+1}• Discussion- Fiscal shocks (τnt , gt)- Ricardian equivalence- Countercyclical policies

Empirical Evidence on the Effects of Fiscal Shocks

• The "identification problem"

• Effects of tax changes: Romer & Romer (AER 2010)- "narrative" approach- focus on exogenous tax changes:· legislative action (not automatic)· motivated by:

- need to reduce inherited debt/deficit- long term goals

- estimated equations:

∆yt = α +

K∑k=0

βk∆Tt−k + ut

∆yt = α +

K∑k=0

βk∆Tat−k +

K∑k=0

γk∆Tit−k + ut

Source: Romer and Romer AER 2010

Source: Romer and Romer AER 2010

Source: Romer and Romer AER 2010

• Effects of government purchases: Galí, López-Salido and Vallés (JEEA 2007)- fiscal policy rule:

gt =

K∑k=1

φ′kxt−k + εgt

- macroeconomic effects:

zt =

K∑k=0

βkεgt−k + ut

• Effects of fiscal consolidations: IMF WEO (Oct. 2010)- 15 countries, 1980-2009- 173 fiscal consolidations (aimed at deficit reduction)- estimated equations:

zt = α +

K∑k=0

βkft−k + ut

Source: Galí, López-Salido and Vallés, JEEA 2007

Source: IMF WEO, October 2010

Source: IMF WEO, October 2010

Source: IMF WEO, October 2010

Debt and Deficit Dynamics

• Government budget constraint:Bgt = (1 + rt−1)B

gt−1 + Gt − Tt

• DeficitDEFt ≡ rt−1B

gt−1 + Gt − Tt

• Primary deficitDEF p

t ≡ Gt − Tt• Structural (or cyclically adjusted) deficit

DEF ∗t ≡ rt−1Bgt−1 + G(Y ∗t )− T (Y ∗t )

• Structural primary deficitDEF p,∗

t ≡ G(Y ∗t )− T (Y ∗t )

Debt Dynamics:Bgt = (1 + rt−1)B

gt−1 + DEF p

t

bgt =

(1 + rt−11 + gt

)bgt−1 + def pt

where bgt ≡ Bgt /Yt, def

pt ≡ DEF p

t /Yt and gt ≡ (Yt − Yt−1)/Yt−1

∆bgt =

(rt−1 − gt

1 + gt

)bgt−1 + def pt

Stationary case:

∆bgt =

(r − g1 + g

)bgt−1 + def p

Stability condition:r < g

Steady state debt ratio:

bg =1 + g

g− r defp

Primary Deficit and Debt Dynamics: r<g

11g pt

r g b defg −

−+ +

defp

> > > > > > > > > > > > > > > > < < < < < < <

gtb∆

1gtb −

Primary Deficit and Debt Dynamics: r<g

def p0

> > > > > > > > > > > > > > > > > > > > > < < < <

def p1

gtb∆

1gtb −

11g pt

r g b defg −

−+ +

Primary Deficit and Debt Dynamics: r>g

defp

< < < < < < < < < < < < < < < <

11g pt

r g b defg −

−+ +

gtb∆

1gtb −

> > > > > >

Primary Deficit and Debt Dynamics:

11

( )1

gg ptt

r b g b defg

−−

−+ +

defp

> > > > > > > > > > > > < < < < < < <

gtb∆

1gtb −

> > > > >

1( )gtr b −

Debt Reduction Strategies

• Lower primary deficit (↓ def p)• Higher growth• Financial repression (rg < r)

• Default or debt restructuring (or inflation)• Sale of public assets (privatization)

Short-run vs. permanent fixes.

Fiscal Balance

Debt Ratio

Source: Dallas Fed

Source: IMF Fiscal Monitor, April 2018

Source: IMF Fiscal Monitor, April 2019

Fiscal Rules in Europe

• EU treaty:- "no bailout" clause (Art. 125 TFEU)- "no monetization" clause (Art. 123 TFEU)- limits to deficits and debt ratios (Art. 126 TFEU + EDP Protocol; 3/60);

• Stability and Growth Pact (1997):- "preventive branch": fiscal balance or surplus in the medium-term (stability andconvergence programs)- "corrective branch": excessive deficit procedure (EDP): correction in 2 years, sanc-tions (0.2% of GDP)- 2005 Reform: focus on "structural deficit" (<1% medium term; 0.5% correction peryear); more exceptions.

• Euro-Plus Pact (May 2011):- strengthening of sanctions ("inverted qualified majority")- EDP for excessive debt (>60%); annual correction of 1/20- ceiling on government spending growth (= medium term GDP growth)

• Fiscal Compact (March 2012)- need for national "fiscal stability laws"- maximum structural deficit = 0.5% (1% if deb-ratio is less than 60%)

• October 2012: European Stability Mechanism starts operating• Spain- September 2011: Constitutional amendment (Art 135)- April 2012 "Ley Estabilidad Presupuestaria": structural deficit<0%, 0.8% adjust-ment until 2020

Bailouts- Greece I (May 2010), 110bn- Ireland (November 2010), 85bn- Portugal (May 2011), 78bn- Greece II (March 2012), with restructuring, 130bn- Spain (June 2012), bank capitalization, 100bn- Cyprus (April 2013), 10bn- Greece III (August 2015), 86bn

Euro Area Government Bond Spreads

Source: Dallas Fed