Optimal Fiscal Policy and the Banking Sector

Matthew Schurin

No 2012-40, Working papers from University of Connecticut, Department of Economics

Abstract: What should the government’s fiscal policy be when banks hold significant amounts of public debt and the government can default on its debt obligations? This question is addressed using a dynamic stochastic general equilibrium model where banks face constraints on their leverage ratios and adjust lending to satisfy regulatory requirements. In response to negative productivity shocks, the government subsidizes the banking sector by increasing bond repayments. This helps to sustain private sector lending. When government consumption exogenously increases, however, the government optimally taxes banks and partially defaults on its debt. Debt issuance is procyclical to ensure equilibrium in the deposit market. With an opening of the economy, the government uses less aggressive tax and default policies. JEL Classification: E32, E62, F41, H21, H63 Key words: Business Fluctuations, Debt, Fiscal Policy, Government Bonds, Ramsey Equilibrium, Optimal Taxation

Pages: 71 pages
Date: 2012-11, Revised 2013-07
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mac and nep-pbe
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