Optimal Fiscal Policy

52 Pages Posted: 22 May 2013

See all articles by Jasper Lukkezen

Jasper Lukkezen

CPB Netherlands Bureau of Economic Policy Analysis; Utrecht University

Coen N. Teulings

Tinbergen Institute

Multiple version iconThere are 2 versions of this paper

Date Written: May 21, 2013

Abstract

This paper derives and estimates rules for fiscal policy that prescribe the optimal response to changes in unemployment and debt. We combine the reduced-form 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 reduced-form 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: optimal control, optimal policy, fiscal policy rules, fiscal consolidation, debt sustainability

JEL Classification: E600, H600

Suggested Citation

Lukkezen, Jasper and Teulings, Coen N., Optimal Fiscal Policy (May 21, 2013). CESifo Working Paper Series No. 4241. Available at SSRN: https://ssrn.com/abstract=2267737

Jasper Lukkezen (Contact Author)

CPB Netherlands Bureau of Economic Policy Analysis ( email )

P.O. Box 80510
2508 GM The Hague, 2585 JR
Netherlands

Utrecht University ( email )

Vredenburg 138
Utrecht, 3511 BG
Netherlands

Coen N. Teulings

Tinbergen Institute ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

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