Three Essays on Built-in Stability

Jean-Paul Lam Yik Shing


This dissertation comprises three essays. The first essay examines the implications of alternative fIscal regimes on output volatility using a series of closed economy models. Two fiscal regimes are considered: a flexible fiscal regime ("Keynes") whereby the government uses fIscal policy in a countercyclical fashion, increasing the budget defIcit when output falls and a rigid fiscal regime ("Hoover") whereby the government balances the budget at each point in time by changing its expenditure. In this essay, I explore which fiscal regime is able to limit output volatility in the presence of shocks. The model involves two important features that make it possible for the flexible approach to fiscal policy to be less not more stabilizing for output. By issuing more bonds during a downturn (to finance temporary deficits), governments create an obligation to work down the debt-ratio in the future. Thus, while conducting fiscal policy a la "Keynes" can reduce the size of a recession initially, it can delay and weaken any eventual recovery and hence make the recession last longer. On the other hand, while the impact effect of a negative shock under "Hoover" is bigger, the speed at which the economy recovers is faster as this fIscal regime avoids the destabilizing part of bond-financed deficits. As a result, depending on the magnitude of the impact and the speed at which the economy recovers from a downturn, output volatility can be higher under "Keynes" . The second feature highlighted in this essay which raises the probability that a rigid annual balanced-budget approach can be superior in reducing output volatility, involves the interaction between fiscal and monetary policy. Monetary policy is modeled by deriving the interest-rate setting rule that is appropriate for meeting the central bank's goal (assumed to be an expected future inflation rate of zero), taking the rest of the macro model as the bank's constraint. Since fiscal policy is part of the system, monetary policy adjusts whenever the fiscal regime changes. In particular, since the rigid fiscal regime avoids the destabilizing part of a bond-financed deficit, the central bank finds it appropriate to put less weight on stabilizing long-term expectations and more weight on the deviations of real output from its target. Traditional analyses of fiscal policy have not allowed for such an endogenous reaction of monetary policy. My results for this essay indicate that the degree of forward-lookingness, the nature of the shock hitting the economy and to some extent the degree of price stickiness are important factors in determining the choice of the best fiscal regime. I find that in an number of cases, the "Hoover" approach minimizes output volatility. In particular, in the micro-based specification and forward-looking version of the model, at least for demand shocks and some common ways of specifying prices, output volatility can be reduced by moving away from a flexible fiscal regime toward one that involves rigid annual budget targets. To check for the robustness of my results, a series of sensitivity tests are performed. The second essay extends the analysis developed in the first essay of this thesis to the small open economy case. The same issues are examined but this time using a richer and more complex framework. Several changes are introduced in this essay. However, despite these changes, I find that the results from this chapter are very similar to those obtained in the closed economy framework. In particular, I find that the "Hoover" approach receives more support when the more forward-looking version of the model is used while the flexible regime dominates the rigid approach when the more backward-looking version of the model is assumed. In addition to the "Keynes" vis "Hoover" debate, several other interesting findings emerge from this essay. For example, in the second essay, I find that a more conservative central bank is more desirable when demand and supply shocks are persistent. This verifies the finding of many other studies which have obtained an identical result using the same framework which however excludes government and open economy considerations. As in the previous chapter, I perform a series of sensitivity tests. The third essay continues this shift in emphasis from fiscal to monetary policy. The third essay is based on two propositions. First the goal of price stability can be achieved with exchange rate targeting, but with also exchange rate flexibility combined with a monetary policy that targets either the price level or an index of wage rates. The three different monetary regimes are assumed to generate the same outcome regarding long-term inflation. As a result, the choice among these alternative monetary regimes can be made on the basis of which fiscal regime delivers the most built-in stability for real output. Second, this essay is based on the beliefthat changes in aggregate demand are a very important source of disturbance in the economy. Since these shocks are costly to society, they generate the desire for built-in stability. The three monetary regimes are compared using several models and I assume that the central bank can target any of these regimes in a modest or aggressive fashion in the face of temporary and on-going shocks in demand. An the models in this essay involve consistent exchange rate expectations and through the existence of intermediate imports, supply-side effects of exchange rate changes. Moreover, all models also incorporate the possibility of an imperfect pass-through of exchange rate movements on prices. My results from this essay indicate that in all of these models, either price level or wage-rate targeting can do as well, or better than exchange rate targeting. However, exchange rate targeting is often the second best policy while the other two monetary regimes switch between the first and third best ranking. Hence exchange rate targeting appears to be more robust to model uncertainty compared to the other two targeting regimes and hence emerges as an appealing compromise.