In Praise of Fiscal Restraint and Debt Rules. What the Euro Zone Might Do Now

Andrew Hughes Hallett

No 5043, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper attempts to reconcile the need for flexibility in fiscal policy, with the need for credibility and consistency in monetary policies. The idea is to generate fewer conflicts between policies but greater discipline within them. We assume an independent central bank and restraints on the use of national fiscal policies. Using a theoretical model, we examine the consequences of assigning leadership to fiscal or monetary policies to exploit the implicit (rule based) coordination available under standard transmission mechanisms, but where priorities and targets differ between policy makers. This works best with fiscal leadership: we introduce a debt rule (with hard or soft targets) to precommit fiscal policies over the longer term, but use monetary independence to guarantee credibility and discipline in the short run stabilization policies. Compared to the uncoordinated solution now operating in Europe, inflation biases are lower and debt repayments higher for no loss in output volatility. That corresponds to the experience of the UK, our benchmark case, whose empirical reaction functions show fiscal leadership. Across ten OECD countries, these gains are estimated to be worth 2%-4% of GDP.

Keywords: Stackelberg leadership; Institutional coordination; Debt rule; Soft targets (search for similar items in EconPapers)
JEL-codes: E52 E61 F42 (search for similar items in EconPapers)
Date: 2005-05
New Economics Papers: this item is included in nep-eec and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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