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  Reinstating Fiscal Policy as a Stabalisation Device

Dr Campbell Leith
University of Glasgow

Professor Simon Wren-Lewis
University of Exeter

Dr Campbell Leith
Department of Economics
University of Glasgow
Room S111
Adam Smith Buliding
G12 8RT

Tel: 0141 330 3702
email: c.b.leith@socsci.gla.ac.uk

Duration of Research
September 2005 - August 2008

A recent discussion paper issued by HM Treasury (2003) has raised the possibility of reinstating a stabalisation role for discretionary fiscal policy. This research project will seek to evaluate such proposals, particularly when monetary policy instruments have been relinquished as part of EMU. We would seek to extend the recent literature on optimal monetary policy, which utilises utility-based measures of welfare in micro-founded general equilibrium models, to allow for a richer description of fiscal policy. Specifically, we would drop the common fiction that fiscal policy can eliminate the distortions due to imperfect competition in labour and product markets through the use of an appropriate combination of subsidies and lump-sum taxation. Instead, we would wish to consider a situation where fiscal instruments are inherently distortionary. Adopting this basic premise, we would then seek to develop a series of models appropriate for assessing the ability of alternative fiscal instruments to perform a stabalisation role. Since the derivation of welfare functions is model specific we would hope to be able to consider which objectives are appropriate to a discretionary fiscal policy in a variety of models (open economy models under EMU, models with capital, models with durable consumption goods etc). We would also wish to develop numerical descriptions of optimal policy in models where analytical derivation of welfare functions is intractable. Finally, within this framework, we would examine specific aspects of recent proposals for reinstating fiscal policy in a stabalisation role. For example, we would investigate under what circumstances adopting a 'trigger strategy' for fiscal policy, whereby discretionary fiscal policy is only implemented for significantly large output gaps, can be justified, and whether or not there is any role for debt targets in enhancing reputation or ensuring intergenerational equity.

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Last updated November 2005
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