Fiscal rules and output volatility

In this paper, we extend the neoclassical model of Baxter and King (1993) to assess the effects of two alternative fiscal rules on the business cycle. The rules we analyze are similar to those implemented in practice by some countries, such as limits on the structural fiscal deficit (which eliminates the effects of the business cycle on tax revenue) and limits on the conventional fiscal deficit. We focus our analysis on a model calibrated to reproduce the characteristics of the Peruvian economy. In this model, we evaluate the effects on short-run dynamics and the conditions for equilibrium stability. We find that the structural fiscal deficit rule results in a countercyclical fiscal policy stance, which significantly reduces output volatility. Furthermore, we find that a condition for the structural rule to be implemented is that nonfinancial public spending must react in a proportion greater than one to changes in financial expenditures. (Audio: Department of Economic Publications)