Stability Consequences of Fiscal Policy Rules

Using an optimisation based model with endogenous labour supply and a proportional tax rate we compare the stabilising properties of dif-ferent fiscal policy rules. The economy is affected by shocks from both government spending and technology. The fiscal policy rule can be based on government liabilities or the government budget deficit. As both are given as measures of fiscal policy performance in the Stability and Growth Pact (SGP), we also use a fiscal policy rule based on the combination of the two. We compare the accounting definition of deficit with the eco-nomic definition which takes inflation into account. The fiscal policy rule based on debt, wiht monetary policy consistent with the Taylor princi-ple, results in an unstable solution. However, a fiscal policy rule based on deficit produces stable solutions with a wide range of fiscal policy pa-rameters. Moreover, we find that putting more weight on the deficit than the debt in the fiscal policy rule creates less cyclical responses to shocks. Finally we find out that the SGP definition of deficit performs as well as the real deficit based on the government budget constraint. JEL classification: E52, E31, E6