Working Paper: CEPR ID: DP9473
Authors: Jasper Lukkezen; Coen N. Teulings
Abstract: This paper derives and estimates rules for fiscal policy that prescribe the optimal response to changes in unemployment and debt. We combine the reducedform model of the economy from a linear VAR with a non-linear welfare function and obtain analytic solutions for optimal policy. The variables in our reducedform model ? growth, unemployment, primary surplus ? have a natural rate that cannot be affected by policy. Policy can only reduce fluctuations around these natural rates. Our welfare function contains future GDP and unemployment, the relative weights of which determine the optimal response. The optimal policy rule demands an immediate and large policy response that is procyclical to growth shocks and countercyclical to unemployment shocks. This result holds true when the weight of unemployment in the welfare function is reduced to zero. The rule currently followed by policy makers responds procyclically to both growth and unemployment shocks, and does so much slower than the optimal rule, leading to significant welfare losses.
Keywords: debt sustainability; fiscal consolidation; fiscal policy rules; optimal control; optimal policy
JEL Codes: E6; H6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal fiscal policy requires a procyclical response to growth shocks (E62) | stabilization of fluctuations around natural rates of growth (E63) |
| optimal fiscal policy requires a countercyclical response to unemployment shocks (E62) | stabilization of fluctuations around natural rates of unemployment (E63) |
| immediate fiscal stimulus to unemployment (J65) | reduction of its impact over time (F69) |
| empirical policy responds procyclically to growth and unemployment shocks (E65) | significant welfare losses (D69) |
| optimal policy rule applied (E61) | substantial reduction in unemployment and debt levels (E69) |
| optimal policy is characterized by a one-year fiscal stimulus followed by neutral policy (E63) | more effective than empirical response (C90) |