Designing Model-Based Fiscal Policy Rules

Perez and Hiebert discuss the role of fiscal policy rules in macroeconomic models. They note that rules are designed to guarantee that the intertemporal budget constraint of the government is satisfied. Rules avoid explosive paths for the debt ratio and influence the adjustment of policy variables against shocks and policy changes. Perez and Hiebert note that rules are generally imposed exogenously and that there is little consensus on their most appropriate formulation. Exogenous rules involve backward-looking behaviour on the part of government, may not take into account the specific features of the shocks, and may not be fully consistent with other sectors of the model. The authors offer an alternative specification in the form of an endogenous fiscal rule which requires the presence of forward-looking agents. The rule is forward-looking and consistent with the set-up of the model. It allows shock-specific fiscal policy responses. Only counter-cyclical automatic adjustments are envisaged.