Fiscal Rules and Discretion under Persistent Shocks
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 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 analyze the optimal fiscal rule when the shocks are persistent. Unlike under i.i.d. 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.
We would like to thank Manuel Amador, Sylvain Chassang, Navin Kartik, Ciamac Moallemi, Emi Nakamura, Ali Shourideh, Paolo Siconolfi, Jón Steinsson, Bruno Strulovici, Steve Tadelis, Aleh Tsyvinski, Iván Werning, Steve Zeldes, seminar participants at Brown, Columbia, Duke, Minneapolis Fed, New York Fed, Princeton, and Yeshiva, and participants at the NBER SI 2012 Political Economy Public Finance workshop and the SED conference for comments. Sergey Kolbin provided excellent research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Fiscal Rules and Discretion Under Persistent Shocks Marina Halac1,2 andPierre Yared1,3,† Article first published online: 3 OCT 2014 DOI: 10.3982/ECTA11207 © 2014 The Econometric Society Issue Econometrica Econometrica Volume 82, Issue 5, pages 1557–1614, September 2014 citation courtesy of