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The Costs of Fiscal Inflexibility


Campbell Leith


University of Glasgow - Department of Economics

Simon Wren-Lewis


University of Oxford - Economics Department

March 2006

World Economy & Finance Research Programme Working Paper No. 0005

Abstract:     
Extending Gali and Monacelli (2004), we build an N-country open economy model, where each economy is subject to sticky wages and prices and, potentially, has access to sales and income taxes as well as government spending as fiscal instruments. We examine an economy either as a small open economy when all three fiscal instruments are freely available, we show analytically that the welfare impact of technology and mark-up shocks can be completely eliminated (in the sense that policy can replicate the efficient flex price equilibrium), whether policy acts with discretion or commitment. However, once any one of these fiscal instruments is excluded as a stabilisation tool, costs can emerge. Using simulations, we find that the useful fiscal instrument in this case (in the sense of reducing the welfare costs of the shock) is either income taxes or sales taxes. In contrasts, having government spending as an instrument contributes very little. The results for an individual member of a monetary union facing an idiosyncratic technology shock (where monetary policy in the union does not respond) are very different. First, even with all fiscal instruments freely available, the technology shock will incur welfare costs. Government spending is potentially useful as a stabilisation device, because it can act as a partial substitute for monetary policy. Finally, sales taxes are more effective than income taxes at reducing the costs of a technology shock under monetary union. If all three taxes are available, they can reduce the impact of the technology shock on the union member by around a half, compared to the case where fiscal policy is not used. Finally we consider the robustness of these results to two extensions. Firstly, introducing government debt, such that policy makers take account of the debt consequences of using fiscal instruments as stabilisation devices, and, secondly, introducing implementation lags in the use of fiscal instruments. We find that the need for debt sustainability has a very limited impact on the use of fiscal instruments for stabilisation purposes, while implementation lags can reduce, but not eliminate, the gains from fiscal stabilisation.

Number of Pages in PDF File: 42

JEL Classification: E32, E60, F41

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Date posted: October 31, 2006  

Suggested Citation

Leith, Campbell and Wren-Lewis, Simon, The Costs of Fiscal Inflexibility (March 2006). World Economy & Finance Research Programme Working Paper No. 0005. Available at SSRN: http://ssrn.com/abstract=941113 or http://dx.doi.org/10.2139/ssrn.941113

Contact Information

Campbell Leith (Contact Author)
University of Glasgow - Department of Economics ( email )
Adam Smith Building
Glasgow, Scotland G12 8RT
United Kingdom
++44 141 330 3702 (Phone)
++44 141 330 4940 (Fax)
Simon J.Q. Wren-Lewis
University of Oxford - Economics Department ( email )
Manor Road Building
Manor Road
Oxford, OX1 3BJ
United Kingdom
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