RDP 2014-02: Fiscal Policy and the Inflation Target 8. Directions for Future Research

The simulations shown in Figure 4 imply that countercyclical fiscal policy, such as we have just seen, can be expected to stabilise the economy, substituting for a higher inflation target.

This result could be developed and refined in several directions. One variation would be to assume model-consistent expectations. However, as discussed in Section 7, it is not clear that this would affect the results. A second useful extension would be to incorporate non-conventional monetary policy, as discussed by Chung et al (2012). This should be included for essentially the same reasons as those I gave for including fiscal activism. A third important challenge is to determine how large will be the shocks hitting the economy. As discussed in reference to Figure 5, the inflation target is sensitive to this assumption unless fiscal policy is very aggressive. Related to this point, interest rates have remained at the zero bound for longer than was expected when my results were finalised. That does not pose problems for the fiscal rule, as extra stimulus measures were also introduced. However, it does highlight the sensitivity of assessments of economic volatility to the sample period from which shocks are drawn.

My simulations quantify substantial benefits from systematic countercyclical fiscal policy. However, in order to make fiscal policy recommendations, it would need to be argued that these benefits exceed the costs. The current version of FRB/US is not specified so as to address this question, because the costs of countercyclical fiscal policy in FRB/US are simply assumed to be unimportant. For example, perceptions of default probabilities do not depend on debt levels, labour supply does not respond to variations in tax rates, and my stimulus rule did not include measurement or other errors. Although these assumptions may be appropriate for many purposes, a more general model would be able to more persuasively address the issue of optimal fiscal policy.