The Value of Constraints on Discretionary Government Policy

29 Pages Posted: 27 Oct 2016 Last revised: 5 Jan 2019

See all articles by Fernando M. Martin

Fernando M. Martin

Federal Reserve Banks - Federal Reserve Bank of St. Louis

Date Written: 2016-02-27

Abstract

This paper investigates how institutional constraints discipline the behavior of discretionary governments subject to an expenditure bias. The focus is on constraints implemented in actual economies: monetary policy targets, limits on the deficit and debt ceilings. For a variety of aggregate shocks considered, the best policy is to impose a minimum primary surplus of about half a percent of output. Most welfare gains from constraining government behavior during normal times, which to a large extent is sufficient to discipline policy in adverse times. Monetary policy targets are not generally desirable as they hinder the ability of governments to smooth distortions. Allowing for the effective use of inflation during transitions is a key component of good institutional design. Debt ceilings are benign, but always dominated by deficit constraints. More pre-commitment to government actions is ineffective in curbing inefficiently high public expenditure.

Keywords: time-consistency, discretion, government debt, inflation, deficit, fiscal constraints, inflation targeting, institutional design, political frictions.

JEL Classification: E52, E58, E61, E62

Suggested Citation

Martin, Fernando M., The Value of Constraints on Discretionary Government Policy (2016-02-27). FRB St. Louis Working Paper No. 2016-19, Available at SSRN: https://ssrn.com/abstract=2859957 or http://dx.doi.org/10.20955/wp.2016.019

Fernando M. Martin (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

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