The Value of Constraints on Discretionary Government Policy

Fernando Martin

No 267, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: Societies design institutions to restrict the behavior of undisciplined governments, which often take the form of simple policy constraints: monetary policy targets, limits on the deficit and debt ceilings. I study their relative effectiveness in a dynamic stochastic model where fiscal and monetary policy are jointly determined. For a variety of aggregate shocks considered, the best policy is always to impose a minimum primary surplus. For an economy calibrated to the postwar US, the surplus should be about half a percent of output. Most welfare gains arise from constraining government behavior during normal times, which to a large extent is sufficient to discipline policy in adverse times. Monetary policy targets are not generally desirable as they hinder the ability of governments to smooth distortions. Allowing for the effective use of inflation to affect the real value of public debt is a critical component of good institutional design. Debt ceilings are benign, but always dominated by deficit constraints.

Date: 2018
New Economics Papers: this item is included in nep-dge and nep-mac
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Working Paper: The Value of Constraints on Discretionary Government Policy (2016)
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