Rules versus Discretion in Fiscal Policy

This paper purports to apply the Kydland-Prescott framework of dynamic inconsistency to fiscal policy by considering the trade-off between output and debt stabilization. The paper shows that, in a static framework, a commitment to debt stabilization is superior to discretion only when the public debt-GDP ratio is sufficiently high. Discretion, though, is always inferior to the commitment to an optimal fiscal rule, which however entails a positive predetermined debt growth. As usual, the introduction of uncertainty determines an additional advantage for discretion, implying a reduction in the net benefit generated by the adoption of a fixed rule. If dynamic considerations are introduced into the model, the optimal fiscal rule is characterized by a positive debt growth in the short-run and debt stabilization in the long-run. Finally, in a dynamic context of repeated strategic games, reputational equilibria may emerge, implying that the optimal fiscal rule could also be implemented without commitment.