Lost in Fiscal Space: Some Simple Analytics of Macroeconomic Policy in the Spirit of Tinbergen, Wicksell and Lerner

J.W. Mason and Arjun Jayadev

No 2015_05, Working Papers from University of Massachusetts Boston, Economics Department

Abstract: The interest rate and the fiscal balance can be thought of as two independent instruments to be assigned to two targets, the path of output and the path of public debt. Under what we term a ’sound finance rule’ the interest rate targets output while the fiscal balance targets public debt; under a ‘functional finance rule’ the budget balance is assigned to the output gap and the interest rate to the debt ratio. The same unique combination of interest rate and fiscal balance will be consistent with output at potential and a constant debt-GDP ratio regardless of which instrument is assigned to which target The stability characteristics of the two rules differ, however. At low levels of debt, both rules converge, but at high levels of debt, only the functional finance rule converges. So contrary to conventional wisdom, the case for countercyclical fiscal policy becomes stronger, not weaker, when the ratio of public debt to GDP is already high. We apply our framework to describe policy generated cycles in the US over the past five decades.

Pages: 29 pages
Date: 2015-12
New Economics Papers: this item is included in nep-mac and nep-pbe
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