Fiscal rules in a monetary economy: Implications for growth and welfare

• Date: 01 February 2020
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/jpet.12389
• Author: Tetsuo Ono

J Public Econ Theory. 2020;22:190–219.wileyonlinelibrary.com/journal/jpet190

|

© 2019 Wiley Periodicals, Inc.

Received: 21 September 2018

|

Accepted: 29 June 2019

DOI: 10.1111/jpet.12389

ORIGINAL ARTICLE

Fiscal rules in a monetary economy:

Implications for growth and welfare

Tetsuo Ono

Graduate School of Economics, Osaka

University, Toyonaka, Osaka, Japan

Correspondence

Graduate School of Economics, Osaka

University, 1‐7 Machikaneyama,

Toyonaka 560‐0043, Osaka, Japan.

Email: tono@econ.osaka-u.ac.jp

Funding information

Japan Society for the Promotion of

Science, Grant/Award Number:

18K01650

Abstract

This study considers two fiscal rules, a debt rule that

controls the debt‐to‐gross domestic product (GDP) ratio,

and an expenditure rule that controls the expenditure‐

to‐GDP ratio, in a monetary growth model with financial

intermediation. Tightening of fiscal rules promotes eco-

nomic growth and thus, benefits future generations.

However, there could be two equilibria of the nominal

interest rates, and the welfare effects of the rules on the

current generation are different between the two equilibria.

In particular, the effects of a decreased debt‐to‐GDP ratio

depend on its initial ratio; a high (low)‐ratio country has no

incentive (an incentive) to reduce the ratio further from the

viewpoint of the current generation’swelfare.Thisresult

provides an explanation for difficulties with fiscal reform in

countries with already high debt‐to‐GDP ratios.

1

|

INTRODUCTION

The emergence and persistence of large fiscal deficits and public debt in many industrial and

developing countries in the last few decades have raised concerns about fiscal sustainability and

led to calls for appropriate adjustment with the use of fiscal rules (International Monetary

Fund, 2009; Schaechter, Kinda, Budina, & Weber, 2012). The fiscal rules control public

spending and/or public debt issuance, which in turn affects allocation of resources across

generations (Fernandez‐Huertas Moraga & Vidal, 2010; Heijdra & Ligthart, 2000; Yakita, 2008).

In particular, recent studies suggest that fiscal austerity programs create trade‐offs between a

negative short‐turn effect and a positive long‐run effect in output (Bom & Ligthart, 2014), and

the corresponding trade‐offs between current generations’loss and future generations’benefit

in terms of welfare (Glomm, Jung, & Tran, 2018).

The studies mentioned above are based on nonmonetary growth models and thus, pay little

attention to monetary factors. However, fiscal rules may influence monetary variables through

the financial markets. For example, increased government debt is associated with increased

money supply through open market operations. This influences the inflation and nominal

interest rates, and thus, may affect the real activity and welfare across generations through

allocative functions of financial markets (Bhattacharya, Guzman, Huybens, & Smith, 1997;

Schreft & Smith, 1997, 1998). Therefore, consideration of monetary factors is necessary for

analyzing the fiscal rule effects on current and future generations.

Following D.W. Diamond and Dybvig (1983), Schreft and Smith (1997, 1998) introduce a role

for private banks that provide liquidity into P.A. Diamond (1965) growth model with

overlapping generations. In this framework, agents are subject to stochastic relocations, and

only currency can be transported between locations. Agents seek to liquidate their holdings of

bonds and capital to obtain currency once they have relocated. Under this environment, Schreft

and Smith (1997, 1998) consider the effects of monetary policy on growth and welfare across

generations via financial markets. However, they assume no direct government expenditures

and taxes, and say nothing about the effect of fiscal rules on growth and welfare. Bhattacharya

et al. (1997), Espinosa‐Vega and Yip (1999, 2002), and Hung (2005) partly overcome this

limitation by investigating the fiscal spending rule effects on economic growth, but these studies

assume no tax or debt rule (Bhattacharya et al., 1997), or no fiscal deficit (Espinosa‐Vega & Yip,

1999, 2002; Hung, 2005).

1

A notable exception is Schreft and Smith (2002), who consider the consequence of a

declining stock of public debt. In their model, there are two separate entities: the treasury and

central bank. The treasury finances public expenditures by labor income taxation and public

debt issues. The central bank creates money, acquires public bonds in the capital market, and

rebates all interest earned on its holding of public debt to the treasury, as in the cases of Japan

and the United States. In particular, the central bank’s balance‐sheet constraint requires that

the value of the bank’s outstanding liabilities (i.e., the monetary base) does not exceed the value

of its holding of government bonds. Within this framework, Schreft and Smith (2002) show that

there could be two equilibria of the nominal interest rates, because the earned interest prevails

over the Laffer curve property with respect to the nominal interest rate, and that the equilibria

are Pareto ranked. Their analysis provides the welfare implications of a debt rule (i.e., a

declining stock of public debt), but the analysis is static in nature, because physical capital

accumulation is abstracted away from their model. Thus, their model provides no growth

implications of the debt rule and its impact on welfare.

To address these issues, this study extends the model of Schreft and Smith (2002) by

assuming Barro (1990)‐type public production services as an engine of economic growth. This

assumption leads to AK technology as in Espinosa‐Vega and Yip (1999, 2002), Hung (2005),

and Bhattacharya, Haslag, and Martin (2009). In addition, we assume two fiscal rules that are

widely used in industrial and developing countries: a debt rule, which keeps the debt‐to‐gross

domestic product (GDP) ratio at a constant rate, and an expenditure rule, which keeps the

expenditure‐to‐GDP ratio constant (Budina, Kinda, Schaechter, & Weber, 2012). Within this

extended framework, the present study demonstrates how the two fiscal rules affect growth

and nominal interest and inflation rates, and how they in turn affect welfare across

generations.

1

Further extensions are undertaken by assuming variations in structural parameters (Gomis‐Porqueras, 2000), various types of private banking systems

(Matsuoka, 2011; Paal, Smith, & Wang, 2013), the presence of banking crisis (Antinolfi & Keister, 2006), multiple production sectors (Ghossoub & Reed, 2014),

changing demand for cash (Ghossoub & Reed, 2010; Schreft & Smith, 2000), the US dollar as a choice of storage value (Antinolfi, Landeo, & Nikitin, 2007), and

allocation of capital and workers (Ghossoub & Reed, 2017).

ONO

|

191