How to Starve the Beast: Fiscal and Monetary Policy Rules

Martin, Fernando M.

doi:10.20955/wp.2019.026

Working Paper

How to Starve the Beast: Fiscal and Monetary Policy Rules

Abstract: Societies often rely on simple rules to restrict the size and behavior of governments. When fiscal and monetary policies are conducted by a discretionary and profligate government, I find that revenue ceilings vastly outperform debt, deficit and monetary rules, both in effectiveness at curbing public spending and welfare for private agents. However, effective revenue ceilings induce an increase in deficit, debt and inflation. Under many scenarios, including recurrent adverse shocks, the optimal ceiling on U.S. federal revenue is about 15% of GDP, which leads to welfare gains for private agents worth about 2% of consumption. Austerity programs should be sudden instead of gradual, and focus on lowering revenue to reduce spending rather than raising revenue to lower debt.

Keywords: time-consistency; fiscal rules; discretion; government debt; inflation; deficit; institutional design; political frictions; austerity; debt sustainability;

JEL Classification: E52; E58; E61; E62;

https://doi.org/10.20955/wp.2019.026