Economic Models - Convex Optimization

The Advantages of Fiscal Leadership in an Economy 79
imply a Stackelberg follower role or independence for monetary policy,
easing the competition (externalities) among policy instruments.
The ECB results look quite different. Once fiscal effects are included,
the concentration on inflation control is much reduced and the forecast
horizon shrinks to six months. Moreover, a feedback element, to correct
the past mistakes, comes in. At the same time, output stabilization becomes
less important, which implies that the symmetric targeting goes out. Instead,
monetary policy now appears to react to fiscal policy, but with the “wrong”
sign: the larger the primary deficit, the looser will be the monetary policy.
In this case, therefore, the policies are acting as complements — circumstances,
which call for a primary deficit will also call for a relaxation of the
monetary policy. Thus, we have an evidence of monetary leadership, where
fiscal policy is used as an additional policy instrument.
4.4. Fiscal Reaction Functions in the UK and Eurozone
Many analysts have hypothesized that fiscal policy responses can best be
modeled by means of a “fiscal Taylor rule”:
d t = a t + γgap t + sd γ > 0 (2)
where sd = structural deficit ratio, d t is the actual deficit ratio (d >0
denotes a surplus), 11 and a t represents all the other factors such as the
influence of monetary policy, existing or anticipated inflation, the debt burden,
or discretionary fiscal interventions. The coefficient γ then gives a
measure of an economy’s automatic stabilizers. The European Commission
(2002), for example, estimates γ ≈ 1/2 for Europe — a little more in
countries with an extensive social security system, a little less elsewhere.
And a similar relationship is thought to underlie UK’s fiscal policy (see
HMT, 2003: Boxes 5.2 and 6.2).
The expected signs of any remaining factors are not so clear. The debt
burden should increase current deficits, unless there is a systematic debt
reduction program underway. Inflation should have a positive impact on the
deficit ratio if fiscal policy is used for stabilization purposes, but it had no
effect otherwise. Finally, the output gap should also have a positive impact
on the deficit ratio, if the latter is being used for stabilization purposes —
in which case interest rates should be negatively correlated with the size
11 See Taylor (2000), Gali and Perotti (2003), Canzoneri (2004), and Turrini and in ‘t Veld
(2004) for similar formulations. The European Commission (2002) uses a similar rule, but
defines d>0 to be a deficit. They therefore expect γ to be negative.