ISSUES FOR CONSIDERATION OF FINANCE MINISTER

Issues for Consideration of Finance Minister

Issues for Consideration of Finance Minister

1. Introduction

In large-scale macroeconomic forecasting models, including those used by leading international institutions, the modelling of the fiscal sector involves some type of fiscal closure rule. This rule, or fiscal reaction function, serves a dual purpose. First, and most importantly, its inclusion is used to generate solvency for the fiscal sector, guaranteeing that the intertemporal budget constraint of the government is satisfied and generating model closure. Second, the rule implicitly embodies some description of the behaviour of governments — and how adjustments of fiscal variables are made vis-à-vis their steady state values in the face of shocks or policy changes. As the time path of adjustments in fiscal and other variables in the model are influenced by the formulation of the fiscal rule, its formulation can entail significant economic consequences for the results of model simulations and forecasts. The forecasts and policy simulations based on these models are used in many instances as an important input into policy decision-making. Consequently, the formulation and implementation of fiscal rules can potentially have wide-ranging implications. Yet, the literature surrounding the formulation of fiscal rules has thus far received considerably less attention than the literature on monetary policy rules. (Wren-Lewis, 2000 92-105)

The fiscal rules employed in large macroeconomic forecasting models are usually constructed and calibrated through a process that aims at replicating certain stylised facts in macroeconomic data whilst also providing some theoretically-consistent properties. Within this framework, a multitude of different formulations of a reaction function can rule out unstable debt paths in model simulations, and the criteria which should be used in ranking these is not entirely clear. Moreover, some derivation practices may yield rules, which are not necessarily compatible with the formulation of other sectors of these models. Although several rules used in practice to close macroeconomic forecasting models tend to share similar features, they remain quite diverse in their specification and calibration. Some studies have found through standardised simulations that changing the specification and calibration of these rules can significantly affect model simulation results, for example, see Mitchell, Sault, and Wallis (2000), Bryant and Zhang, 1996a and Bryant and Zhang, 1996b and Barrell, Sefton, and in't Veld (1994).

In this paper, we show that for model closure, the relevant fiscal rule can be specified and calibrated endogenously by means of standard stability analysis theory for rational expectations models as presented in Sims (2002) or Blanchard and Khan (1980). The rule takes the form of a saddle-path equilibrium which is selected by pinning down the stability conditions attached to unstable eigenvalues or imposed by means of appropriate final conditions as in Juillard, Laxton, McAdam, and Pioro (1998). The state-contingent nature of the resulting rule implies an adjustment profile consistent with the dynamic adjustment process of other agents in the model, and the rule is forward-looking insofar as the model is constructed in this way. The rule embodies the pertinent information contained in the economic model via the transversality condition ...