Academic journal article Economic Inquiry

Risk Assessment under a Nonlinear Fiscal Policy Rule

Academic journal article Economic Inquiry

Risk Assessment under a Nonlinear Fiscal Policy Rule

Article excerpt


Countries around the world are establishing nonlinear fiscal rules, whereby governments respond more aggressively to lower deficits when debt is above some threshold level. These policies range from the German-style "debt break," which imposes limits on the deficits, to fiscal rules that intensify fiscal consolidation at high debt levels.

The purpose of this paper is to study the implications of a nonlinear fiscal rule on solvency crisis. Do nonlinear fiscal rules allay the possibility of future insolvency? Does the increased responsiveness suggested by the nonlinear fiscal rules need to be exhibited at low levels of debt? Could fiscal authorities offset the stronger responsiveness at high levels of debt with a weaker responsiveness at low levels of debt without altering the probability of a solvency crisis?

We build on Daniel and Shiamptanis' (2012) framework, where negative shocks, such as the 2007-2009 worldwide financial turmoil, could lead a government to a position where agents refuse to lend, thereby creating a solvency crisis. To restore lending, monetary and fiscal authorities could implement a policy-switch in which the fiscal policy switches to active and the monetary policy to passive, and the post-crisis equilibrium is characterized by the Fiscal Theory of the Price Level (FTPL). (1) Their analysis, however, utilizes a linear fiscal policy rule and assumes that authorities remain in the FTPL regime once they switch. This paper modifies Daniel and Shiamptanis' (2012) dynamic policy-switching model to allow for a nonlinear fiscal policy rule that governs the evolution of the primary surplus relative to GDP and to allow the authorities to switch back to the original regime. An important feature of the nonlinear fiscal rule is that it naturally yields an endogenous stochastic responsiveness to debt to capture changes in policy over time. (2)

We also build on Bohn (1998), who argues that it is sufficient for a sustainable fiscal policy to satisfy the government's intertemporal budget constraint (IBC). Bohn's analysis, however, does not incorporate a fiscal limit on the size of debt, defined as the maximum level of debt that the country can repay (Bi 2012; Bi et al. 2010, 2013; Cochrane 2011; Ghosh et al. 2013). This paper can be viewed as an extension of Bohn (1998) when a country faces fiscal limits. We derive the criteria necessary for a nonlinear fiscal rule to satisfy both the government's IBC and eliminate explosive behavior.

The final contribution of the paper is empirical. We apply the model to Canada, which is often cited as an example of a small open economy that implemented a significant fiscal adjustment (Lloyd-Ellis and Zhu 2001). We estimate a nonlinear fiscal rule with annual data from 1970 to 2012 and utilize it to quantify the probability of a solvency crisis.

The following key results emerge. First, to eliminate explosive behavior the responsiveness of the nonlinear fiscal rule to debt should be larger than Bohn's (1998) criterion. Second, a nonlinear fiscal rule lowers the expected maximum level of debt on the path back to its long-run target and also shortens the expected adjustment time. Third, the strong responsiveness suggested by a nonlinear fiscal rule is very important to reduce the probability of a solvency crisis; however, this strength need not be exhibited until debt is high. As long as the government has a stronger responsiveness at high levels of debt, the responsiveness at low levels of debt has miniscule impact on solvency risk.

This paper is organized as follows. Section II derives the necessary conditions for global stability, and the dynamics leading to a solvency crisis under a nonlinear fiscal rule. Section III estimates the policy parameters of the Canadian fiscal rule and the probability of a solvency crisis. Section IV provides conclusions.


We set up a simple small open economy model with a stochastic endowment. …

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