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2 fiscal authorities have a greater incentive to spend more today under fixed rates than under flexible rates, although they discount the future at the world real interest rate.. By push

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On Fiscal Discipline and the Choice of Exchange Rate Regime

By

Yan Sun

A dissertation submitted in partial fulfillment

of the requirements for the degree of

Doctor of Philosophy Department of Economics New York University May, 2000

JpAN AL

Bell & Howell Information and Learning Company

300 North Zeeb Road

© Yan Sun

All Rights Reserved, 2000

To My Family

iv

ACKNOWLEDGMENTS

I would like to express my sincere gratitude to my advisor, Prof Andres Velasco, for his role in inspiring my research, his constant guidance and encouragement, and most importantly for cultivating my sense of good economic analysis I am also indebted to my dissertation committee members: Prof Mark Gertler, Prof Boyan Jovanovic, Prof Raquel Fernandez and Prof Fabrizio Perri for their generous help and advice

Special thanks go to my husband, Hanzhen Sun, for his endless tolerance and support, and his trust that I would indeed finish my research project I would also like to thank my parents who always give me their full support and love.

ABSTRACT

The conventional wisdom in policy literatures has held that fixed rates induce more fiscal discipline than flexible rates Empirical evidences don't support this view: fixed exchange rate regime is found to be significantly correlated with high budget deficits in Latin American countries and no correlation between high fiscal deficits and any regime is observed in industrial countries The objective of this dissertation is to investigate in great depth the relation between fiscal discipline and the choice of exchange rate regime

Chapter 2 explores the question whether or not fixed rates would induce more fiscal discipline than flexible rates, and if so, under what conditions The choice of exchange rate regime is exogenously given in this chapter Using a standard intertemporal model with fragmented fiscal policy-making, I find: (1) future punishments in the form of currency depreciation against fiscal laxity exist under both fixed and flexible regimes (2) fiscal authorities have a greater incentive to spend more today under fixed rates than under flexible rates, although they discount the future at the world real interest rate (3) in the presence of both factors above, fixed rates will induce more fiscal discipline only if the punishment tomorrow is sufficiently stronger under fixed regime than under flexible regime The third chapter introduces endogenous choice of exchange rate regime, fixed versus flexible, in a bipartisan economy The incumbent's regime choice lies in a trade-off between "tying the hands of future government" and "affecting electoral

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results" I show that the incentive to "tie the hands of its opponent" leads the Right (Left) incumbent to choose fixed (flexible) regime, whereas the incentive to increase its chance of re-election leads the Right (Left) incumbent to choose flexible (fixed) regime

Chapter 4 analyzes the role of government's discount rate in determining the relation between fiscal discipline and the choice of exchange rate regime I show that an impatient government tends to choose fixed regime because it allows the government to run large budget deficits without being punished immediately by high inflation This proves the hypothesis proposed by Calvo (1987) and by Gavin and Perotti (1998).

TABLE OF CONTENTS

Dedication Acknowledgments Abstract

List of Figures List of Appendices Chapter

1 Introduction

2 Do Fixed Rates Induce More Fiscal Discipline or Indiscipline?

2.1 Introduction 2.2 The Model 2.2.1 The representative agent of interest group h 2.2.2 The government

2.2.3 Solving the private agent's problem 2.2.4 The Central Bank's policy rules 2.3 Standard Results as Cases under Special Assumptions of the General Game

2.3.1 Tragedy of the commons 2.3.2 Competitive externality 2.4 Subgame Perfect Equilibrium of the General Game 2.4.1 Equilibrium under fixed rates

vill

iv

xi Xil

2.4.2 Equilibrium under flexible rates 42

2.4.3 The properties of optimal government spendings under

2.4.4 Three distortions of the general dynamic game 48

3 A Political-Economic Model of the Choice of Exchange Rate Regime 67

3.2.3 The choice of exchange rate regime in period one 79

3.3.1 No uncertainty of the electoral result 82

3.4 Trade-off Between Increasing Its Opportunity of re-election and

Optimal government spending

The case of extremely loose monetary policy

r=0.15,6€ =0.5,a =1,k =13

Spending in each period r=0.15,€ = 0.25,a =1,k =18 The median voter's preference

Chapter 1

Introduction

Which exchange rate regime induces more fiscal discipline, fixed or flexible? The conventional wisdom in policy literatures is that fixed rates induce more fiscal discipline though formal economic analysis on this link has yet to be provided Basically, it argues that implementing lax fiscal policies under fixed exchange rate regime will eventually lead to a collapse of the peg, which would imply a big political cost for the policymaker In other words, fiscal laxity today will lead to future punishment This punishment mechanism leads the fiscal policymaker to

be disciplined Tornell and Velasco (1995,1998) argue that fixed rates actually encourage fiscal indiscipline By pushing the inflation cost of fiscal laxity to the future, fixed exchange rate regime induces an impatient policymaker to spend

more The empirical results are mixed Gavin and Perotti (1998) find that fixed rates and large budget deficits are significantly correlated in Latin American countries, but they don’t find such a correlation in industrial countries For the empirical results obtained from Latin American countries, the endogeneity

of exchange rate regime casts some doubts on the causality from fixed rates to fiscal indiscipline

In my dissertation, “On Fiscal Discipline and the Choice of Exchange Rate Regime”, my research objective is threefold:' First, if the exchange rate regime

is exogenously set, do fixed rates impose more fiscal discipline than flexible rates? And if so, under what circumstances? What are the connections and main differences between existing arguments and why do they lead to opposite conclusions? Second, what political and economic factors may affect the govern- ment’s choice of exchange rate regime? Third, what’s the role of government’s subjective discount rate in determining the relation between fiscal discipline and the choice of exchange rate regime? Would an impatient policymaker who is inclined to conduct unsound fiscal policies also tend to choose fixed exchange

‘In Chapter 2, fixed exchange rate regime is defined in a broad sense: the nominal deval- uation rate doesn’t need to be zero under fixed rates Pegged exchange rate regime, in which

the nominal devaluation rate is zero, is considered as a special case of fixed rates In Chapter

3 and 4, the definition of fixed rates is relatively narrow and it actually means pegged regime

I use “pegged” and “fixed” regime interchangeably in Chapter 3 and 4.

rate regime? What’s the empirical implications the above hypothesis?

Chapter 2: Do Fixed Rates Induce More Fiscal Discipline or In- discipline?

My second chapter focuses on the first question: which exchange rate regime provides more fiscal discipline, fixed or flexible? Using a dynamic equilibrium

model, I am able to evaluate the two existing arguments in one framework

and show that each of them tells a different part of the whole story The two arguments lead to opposite conclusions because the conventional wisdom emphasizes the punishment mechanism under fixed rates whereas the model of Tornell-Velasco emphasizes the incentive to spend more under fixed rates My model shows: (1) the punishment mechanism against lax fiscal policy exists under both regimes; (2) by pushing inflation cost of fiscal laxity to the future, fixed rates create an incentive for the government to spend more The final conclusion is that fixed exchange rate regime will impose more fiscal discipline

if the punishment against fiscal laxity is sufficiently stronger under fixed rates than under flexible rates

The initial exchange rate regime, fixed or flexible, is exogenously set by the Central Bank and is not the outcome of any optimization problem Given the

trade-off between public spending and inflation In my paper, I have the case

of “fragmented” fiscal policy-making, in which n fiscal authorities, representing

n interest groups, independently set their spending on local public goods The

n rational fiscal authorities will tend to implement lax fiscal policies, which eventually leads to an end of the original monetary policies under both regimes Punishments, in the form of higher future inflation, exist in both regimes, not just in fixed exchange rate regime as the conventional wisdom claims The dynamic feature of my model ensures the punishments are at work under both regimes When making decisions on public spending today, the fiscal authorities will take into account their situation tomorrow.?- They understand that they have to pay back the inflation cost of their fiscal laxity tomorrow and this will affect their fiscal decisions today The higher the cost they have to pay tomorrow, the less they will spend today This punishment mechanism is one side of the whole story

The dynamics of my model also enables me to explore the other side of the story Due to the dynamic “tragedy of the commons”, the n fiscal authorities tend to spend more today than tomorrow under both regimes, although each of them individually discounts the future at the rate of world real interest More-

Technically speaking, I solve for the subgame perfect equilibrium.

over, the fiscal authorities have a stronger incentive to spend more today under fixed regime, because they understand that under fixed rates, no increase in pub- lic spending would affect the inflation today whereas it will cause the immediate increase of the inflation rate under flexible rates This result doesn’t require any special assumption regarding the discount rate of each fiscal authority

The conventional wisdom misses the fact that fixed regime itself gives the policymaker an incentive to overspend By emphasizing only the punishment mechanism under fixed rates, the conventional wisdom reaches the conclusion that fixed rates impose more fiscal discipline In contrast, Tornell-Velasco (1995,1998) emphasize the other side of the story: the incentive to spend more today under fixed rates Their result can be viewed as an extreme case of my general one Using an essentially static model, they actually get rid of the pun- ishment mechanism By assuming the policymaker discounts the future at the rate lower than the world real interest rate, the incentive for the policymaker

to spend more under fixed rates is kept with no need to introduce dynamics Therefore, for the impatient policymaker who doesn’t worry about the future punishment on its fiscal laxity today, fixed regime actually induces more fiscal indiscipline My model incorporates the two factors I show that fixed rates will

under fixed regime than under flexible zegime

This chapter has several imporiant policy implications The first best policy

to deal with fiscal fragmentation is the centralization of fiscal process Neither regime, fixed or flexible, can solve the fiscal biases generated by fragmented fiscal policy-making The second best policy is to use regime policy to affect fiscal policy-making My paper shows that there is no inherent correlation between exchange rate regime and fiscal discipline Neither fixed nor flexible regime necessarily leads to more fiscal discipline than the other one This can explain the mixed results obtained from current empirical tests On the one hand, fixed rates don’t necessarily lead policymakers to be disciplined even though policymakers face stronger punishment against fiscal laxity under fixed rates This result stands in great contrast with the conventional wisdom in policy literatures On the other hand, although fixed exchange rate regime will collapse in the future, nevertheless, it could induce more fiscal discipline ex-ante under certain circumstances This provides a mechanism whereby it makes sense

to choose fixed exchange rate regime, even though fixed regime may last only

a limited period of time The cases of Mexico (1987) and Argentina (1991) are good examples However, the experience of Latin American countries overall casts doubt on the generality that the policymakers will encounter sufficiently

stronger punishment against their fiscal laxity under fixed rates than under

flexible rates in countries with high political instability

Chapter 3: A Political-Economic Model of the Choice of Exchange Rate Regime

My third chapter deals with the endogeneity of exchange rate regime I con- sider a two-period economy in which two political parties, Left and Right, with different preferences over public spending and inflation alternate in office, as de- termined by rational voters through election The choice of exchange rate regime matters for the incumbent government because it will affect the intertemporal distribution of the inflation cost caused by unsound public spending Fixed rates push the inflation cost to the future government whereas the cost is born

by both the current and future government Therefore, the incumbent govern- ment can strategically use its regime policy to affect the behavior of the future government in its own interest The key assumption in my paper is that the monetary policy of the future government is passive under both regimes, that

is, it has to monetize the budget deficits caused by public spending to remain solvent Although the future government has the freedom to change the ex- change rate regime when it comes to power, the impact on its fiscal policy from

The first part of my paper discusses the scenario when the current regime policy doesn’t affect the election outcome This is roughly applicable to those countries with relatively frequent turnover of the government In such coun- tries, the incumbent government is not concerned with affecting the electoral outcomes because it knows its term will be over anyway In this case, the only strategical role of exchange rate regime for the incumbent government is to “tie the hands of its opponent” should it lose the election We show that the Right party will choose fixed exchange rate regime to restrain spending of the future liberal government whereas the Left party will use flexible regime to induce its

conservative successor to spend more

The second part of my paper introduces the second strategic role of regime choice: using regime policy to affect the electoral result by influencing the pref- erences of the voters The election consideration matters in those countries with relatively stable political and electoral system The rational and forward- looking voters dislike the overspending of the Left and know that the Left party would spend even more under flexible regime With the choice of flexible regime, the Right party could capitalise on the inflationary reputation of the Left and thereby increases its opportunity of getting elected However, it will fail to cap- ture the gains from creating constraints for the Left should it lose the election

The final decision of the Right depends on which side yields more gains, “tying the hands of its opponents” or “increasing its chance of winning the election”

I also analyze the case of the Left in a similar fashion

Chapter 4: Government’s Discount Rate, Fiscal Discipline and the Choice of Exchange Rate Regime

Chapter 2 shows that fixed rates will induce more fiscal discipline only if the future punishment against fiscal laxity is sufficiently stronger under fixed rates than under flexible rates This general result derived in Chapter 2 doesn’t depend on any special assumption about the government’s discount rate How- ever, the discount rate will affect the comparison between fixed and flexible rates since it will determine how seriously a government will take the future punishment against fiscal laxity into account If the government is impatient which doesn’t care about future punishments, fixed rates will induce less fiscal discipline This is exactly the point made by Tornell-Velasco (1995, 1998) Chapter 4 further explores the role of government’s discount rate by in- troducing the choice of exchange rate regime into Tornell-Velasco’s framework (1995) Calvo (1987) remarked that a politician whose tenure is over in the near future will tend to choose exchange-rate-based stabilization programs because

appears to be successful Gavin and Perotti (1998) also suggested a similar point In this chapter, I show that an impatient government tends to choose fixed exchange rate regime because fixed rates allow the government to spend more without causing an immediate increase in inflation rate This confirms the point made by Calvo (1987), and by Gavin and Perotti (1998)

It has become a stylized fact that impatient governments (countries with high political instability) are inclined to run lax fiscal policy Therefore, the analysis of this chapter implies that impatient governments (countries with high political instability) tend to run large fiscal deficits and choose fixed rates at the same time This leads to the following questions: How shall we interpret the empirical result that fixed exchange rate regime and large fiscal deficits are significantly correlated in Latin American countries? Is there really causality from fixed rates to fiscal indiscipline in the empirical result of Latin American countries? In the current framework, I show that the joint endogeneity of fiscal laxity and fixed exchange regime doesn’t contradict, but rather depend on the causality from fixed rates to fiscal indiscipline An impatient government tends

to choose fixed rates just because it can spend more under fixed rates than under flexible rates, which is exactly the point made by Tornell-Velasco In other words, the endogeneity of fixed exchange rate regime in this framework

10

depends on the fiscal implication of fixed exchange rate regime

Chapter 2

Do Fixed Rates Induce More

Fiscal Discipline or Indiscipline?

‘In this chapter, I use “fixed rates” and “fixed exchange rate regime”, “flexible rates” and

“flexible exchange rate regime” interchangeably

?Setting up a game of incomplete information with imperfect monitoring, Canavan, C and Tommasi M.(1997) argue that an exchange rate anchor provides more macroeconomic

discipline because it’s much easier for the public to monitor the nominal exchange rate more easily than other variables With the exchange rate anchor, the public could readily detect

12

argument is that implementing lax fiscal policies under fixed rates will even- tually leads to a collapse of the peg, which would imply a big cost for the policymaker In other words, lax fiscal policy today would lead to punishments tomorrow This punishment mechanism under fixed exchange rate regime leads the policymaker to be disciplined Tornell and Velasco (1995,1998) argue, con- trary to the conventional wisdom, that fixed rates induce more fiscal indiscipline

By pushing the inflation cost of fiscal laxity to the future, fixed exchange rate regime actually induces the impatient policymaker to spend more The empir- ical results are mixed Gavin and Perotti (1998) find that fixed exchange rate regime and large budget deficits are significantly correlated in Latin American countries, but they don’t find such correlation in industrial countries

The objective of this chapter is to investigate in greater depth the relation between exchange rate regimes and fiscal discipline Using a standard intertem- poral model with fragmented fiscal policy-making, I am able to evaluate those two opposite arguments in one framework I show that the two arguments lead

to opposite conclusions because each of them emphasizes only part of the whole story The conventional wisdom emphasizes the punishment mechanism under

bad government behaviors and threaten punishment But they didn’t directly address the

effects on fiscal policy of different exchange rate regimes

fixed exchange rate regime while Tornell and Velasco emphasize the greater in- centive to spend more under fixed exchange rate regime My dynamic model shows that on the one hand, punishment mechanism against lax fiscal policy ex- ists under both regimes; on the other hand, fixed rates do give the policymaker

a greater incentive to spend more by pushing inflation costs to the future In the presence of both factors above, fixed exchange rate regime will impose more fiscal discipline only if the future punishment is sufficiently stronger than that under flexible regime

My model is an extension of Tornell-Velasco’s two-period model with price flexibility, perfect foresight and perfect capital mobility The inflation rate is the same as nominal devaluation rate regardless of exchange rate regimes The tax rate is exogenously fixed in this model and I will endogenize government spending in each period The following two assumptions are adopted from their model The first one is that the exchange rate regime of period 1, fixed or flexible, is exogenously set by the Central Bank and not the outcome of any optimization problem The CB chooses to fix the nominal devaluation rate in the case of fixed exchange 6 rate regime’, or to fix the nominal mone gl y er owth rate

in the case of flexible exchange rate regime Given the exchange rate regime set

by the CB, the optimizing fiscal authority chooses the fiscal policy in a trade-off between government spending and inflation The second assumption is that the

CB can only precommit to its monetary policy for a limited period of time under both regimes In other words, the CB’s policy suffers credibility problem The initial monetary policies under both regimes collapse in the second period and the CB has to monetize budget deficits to keep the government solvent Tornell and Velasco provide both empirical and theoretical reasons for this assumption Here I want to mention an additional reason: the CB may choose to precommit only for a finite time Gabriel de Kock and Vittorio Grilli (1993) argue that the collapse of exchange rate may be consistent with optimal policies because

it allows the government to meet large government spending at certain period However, my model differs from Tornell-Velasco’s in two key aspects In Tornell-Velasco’s model, the distortion that leads the fiscal authority to spend more than is socially optimal is exogenously assumed By introducing frag- mented fiscal policy-making, I am able to provide microfoundation for fiscal distortions In my model, the society consists of n interest groups, each of which can influence fiscal authorities to set the government spending on local

public goods at their desired levels.> The interaction between the n fiscal author- ities over time will generate two fiscal distortions The first one is “competitive externality”, as defined by Aizenman (1992) With a weak CB, whose mone- tary policies are of limited duration, and strong fiscal authorities, the benefits from spending accrue entirely to each interest group whereas the inflation cost

is shared by all groups This gives each fiscal authority a spending bias The second distortion is “tragedy of the commons” The n fiscal authorities share one common property: government net assets Each of them has a tendency to spend more today due to the fear that there will be less left tomorrow since other fiscal authorities will take more today The final result is that each fiscal authority spends more in period 1 and a debt is left for period 2 This occurs although there is no reason for intertemporal smoothing: each fiscal authority discounts the future at the world real interest rate In sum, fragmented fiscal policy-making generates structural biases which eventually lead to large fiscal deficits Neither regime, fixed or flexible, can solve the fiscal structural biases Given that, I ask the question: which exchange rate regime, relative to the other one, would induce the fiscal policymakers to spend less?

°For more theoretical and empirical discussions on fragmented fiscal policy-making, see

papers collected in Fiscal Institutions and Fiscal Performance, edited by James M Poterba

and Jurgen von Hagen (1999)

16

The second key difference is that my model is dynamic while Tornell-Velasco’s model is essentially static In their model, the fiscal authority chooses its opti- mal spending only once No discussion about the optimal government spending

in the second period exists in their model At the beginning of period 1, the fiscal policymaker decides how much to spend for both period 1 and period 2.6 The fiscal authority is assumed to be able to commit to its spending plan In

my model, the n fiscal authorities independently choose their spending on local public goods Due to lack of cooperation among n fiscal authorities, there is

no guarantee that they would precommit The well-known time-inconsistency problem occurs The optimizing fiscal authorities will make spending decisions twice: at the beginning of each period Moreover, when they make decisions at the beginning of period 1, they will take into account their optimal behaviors

at the second period.”

The dynamics of my model enables me to explore the role of two factors, namely, the punishment mechanism under both regimes and the greater incen- tive to overspend under fixed regime, that may affect the comparison between

®This is the reason why Tornell and Velasco could derive the same result no matter whether the fiscal authority makes transfer only in period 1 (1995) or makes transfers in both periods (1998)

Technically speaking, my equilibrium is subgame perfect

fixed and flexible regime in a different way In this paper, the rational and optimizing fiscal authorities in a divided government structure tend to imple- ment lax fiscal policies The dynamic feature of my model could accommodate the fact that punishments are at work under both regimes Since each fiscal authority will look into the future when making spending decision today, it un- derstands that it has to pay back the inflation cost of fiscal laxity tomorrow under both regimes This will in turn affect its fiscal decision today The higher the inflation cost they have to pay tomorrow, the less they will spend today This serves as a punishment mechanism in the model I show that punishment mechanism exists under both regimes, not just in fixed exchange rate regime as the conventional wisdom claims

The dynamics of my model also reveals that the incentive to spend more today is greater under fixed rates, although they tend to spend more today than tomorrow under both regimes The difference between fixed rates and flexible rates lies in the intertemporal distribution of inflation cost of fiscal laxity Under fixed rates the inflation cost is pushed to the future while under flexible rates it

is spread across time Each optimizing fiscal authority understands that under fixed rates, no increase in public spending would affect the inflation today,

whereas it will cause an immediate increase of the inflation rate under flexible

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rates In other words, fiscal authorities are punished immediately under flexible

rates while the punishment is delayed to tomorrow under fixed rates This gives each fiscal authority a greater incentive to spend more today under fixed rates The dynamic distortion of “tragedy of the commons” is strengthened under fixed rates This result doesn’t depend on any special assumption about fiscal authorities’ discount rate

Putting the two factors above together, I reach the general conclusion: fixed rates will impose more fiscal discipline only if the punishment tomorrow is suf- ficiently stronger under fixed rates than under flexible rates Fixed rates and flexible rates are not equivalent even though each fiscal authority discounts the future at the world real interest rate, in contrast to Tornell-Velasco’s result

My general result has several important implications First, there is no inherent correlation between exchange rate regime, fixed or flexible, and fis- cal discipline Neither regime necessarily leads to more fiscal discipline than the other This can explain the mixed results obtained from current empirical texts Second, stronger punishment against fiscal laxity under fixed rates doesn’t nec- essarily mean that policymakers will be disciplined This result stands in great contrast to the conventional wisdom in policy literatures Last, although fixed

more fiscal discipline ex-ante under certain circumstances Since most fixed exchange rate regimes last only a limited period of time in real world, some economists and policymakers start to wonder why bother fixing exchange rates

in the first place knowing that it will collapse later on This Paper generates a mechanism whereby it makes sense to choose fixed exchange rate regime, even though fixed regime lasts only a limited period of time

The conventional wisdom fails to notice that fixed exchange rate regime does give the policymaker a greater incentive to overspend by pushing costs to the future and that fiscal laxity today leads to punishments tomorrow under flexible rates as well, not only under fixed rates Emphasizing only the punishments under fixed rates, it concludes that fixed rates induce more fiscal discipline The argument of Tornell-Velasco can be viewed as an extreme case of my general result, namely, fixed rates induce more indiscipline for the policymaker who doesn’t worry about future punishment Their assumption that the policymaker

is impatient and short-sighted gives rise to the same result as my dynamic model does, that is, there is a greater incentive for the fiscal policymaker to spend more today under fixed rates But, punishment mechanism, which is another integral part of my dynamic model, is absent in their static model Therefore, they conclude that fixed rates impose more fiscal indiscipline for the impatient

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policymaker

In my model, the “tightness” of the monetary policy under fixed rates will affect the degree of fiscal discipline it induces, as well as under flexible rates Based on different assumptions about the “tightness” of monetary policy, two special cases are discussed to illustrate the general analysis above One is the case when the monetary policy under either regime is very loose: the devaluation rate and the nominal money growth rate approach the upper limit.’ In this

extreme case, fixed rates and flexible rates are equivalent since the incentive to

overspend under fixed rates disappears in the limit and the future devaluation punishments under both regimes are the same

The second experiment is the case of pegged regime with zero inflation rate and floating regime with zero nominal money growth rate I show that the inflation rate in period 2 is higher than that in period 1 under both regimes, that

is, future punishments against fiscal laxity exist under both regimes Moreover, the inflation in period 2 is always higher under pegged regime than floating

regime Facing a stronger punishment, the fiscal authorities have to spend less

in period 2 under pegged regime than under floating However, the stronger punishment under pegged regime doesn’t necessarily lead the policymaker to be disciplined because the fiscal authorities have a greater incentive to spend more

in period 1 under pegged regime

The chapter is organized as follows Section 2.2 presents the general model Section 2.3 discusses some standard results as special cases of the general model Section 2.4 solves for the subgame perfect equilibrium under both regimes and gives a general comparison between the two regimes In Section 2.5, comparisons

of two special cases are carried out and some numerical examples are given In Section 2.6, I discuss policy implications and conclude this chapter

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sense, I have the case of “fragmented” fiscal policy-making

2.2.1 The representative private agent of interest group

the same and are defined as:

Let r be the exogenous world real interest rate For simplicity I also assume the private agent’s subjective discount rate is the same as the real interest rate The

domestic nominal interest rate is defined asi, = r+7, The private agent of each

group has an initial stock of real bonds f,,9 and an initial holding of nominal money Mj,9 In period 1 she receives a constant income y, a lump-sum transfer gn,1 and pays income taxes ry Then she chooses her private consumption c;, 1, adjusts her holdings of real bond and real money to fai and mz) = a

l

respectively In the second period she receives another Gn,2 and y She uses up

all her incomes (g;,2 and y) and accumulated wealth (f,, and zn„¡) to pay the

income tax, inflation tax and consumption ch 92

The private agent’s utility function of group h is given by

u(Car) + (5) (mzo)£=9 + log(gn,1)

1

+ (Fe) le + (S1) màC+ log(ona)] (22)

where € is assumed to lie between 0 and 1 to ensure that the economy is always

on the upward-sloping side of Laffer curve Note that the Mnrz-1 is the real balance chosen by private agent h at the end of period t-1 and carried over to

24

period t

The private agent’s budget constraint of group A for period 1 is given by:

(1 +1) (fro + Maro) +(1—7)y + gna = Ch timag + mani + faa (2-3)

and for period 2:

(L+7r)(fai +mai) + (1—T)y + gro = Cho t+ i2mar (2-4)

Then I could obtain the consolidated budget constraint of both periods for private agent h:

9h,2 l+r