How to Starve the Beast: Fiscal and Monetary Policy Rules

Abstract

Societies have come to rely on simple rules to restrict the size and behavior of governments: constraints on monetary policy, revenue, budget balance and debt. I study the merit of these constraints in a dynamic stochastic model in which fiscal and monetary policies are jointly determined. Under several specifications, a revenue ceiling is the only rule that effectively induces the government to lower spending and dominates other policy constraints in terms of welfare by an order of magnitude. However, the reduction in spending is modest and comes at the cost of higher debt and inflation. Monetary policy rules are not desirable as they severely hinder distortion-smoothing and may lead to large welfare losses if implemented incorrectly. Budget balance and debt rules are generally benign, with the former being always preferable to the latter. All types of fiscal rules are usually best implemented at all times, but can be suspended in adverse times, often at a minor cost.