The Performance of Monetary and Fiscal Rules in an Open Economy with Imperfect Capital Mobility

By Marcela Meirelles Aurelio
January 2005 
RWP 05-01
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

      This paper studies monetary and fiscal policy rules, and investigates the characteristics of optimal policies. The central focus of the paper is on the comparison of two types of fiscal rules: a balanced budget and a target for the primary surplus. Balanced budget rules (or, more generally, numeric ceilings to the overall budget deficit) are criticized because they may dictate higher taxes in periods of weak economic activity. The primary surplus rule, in contrast, has a less pro-cyclical nature, given that it does not require higher fiscal austerity in periods when the cost of servicing public debt is higher. In a nutshell, it allows a higher degree of tax smoothing. It is not clear, however, if (inevitable) fiscal adjustments should be postponed. These issues are investigated in the context of a dynamic stochastic general equilibrium model that describes an open economy, with capital accumulation, and where nominal rigidities are present. The model shows that previous findings drawn from open economy models—in particular with respect to the characteristics of optimal monetary policy—do not hold once the implications of certain fiscal regimes are taken into account, and once different scenarios concerning the degree of capital mobility are considered. The model is calibrated and simulated for the case of Brazil, a country that since 1999 has targets for inflation and for the primary surplus. The main finding is that a fiscal regime characterized by a target for the primary surplus delivers superior economic performance, a property captured by the shape of the efficient policy frontier. 

Keywords: Fiscal and monetary policy rules, distortionary taxation, inflation target

JEL Codes: E5, E6, F4, H3, H6

Marcela Meirelles Aurelio  is an economist at the Federal Reserve Bank of Kansas City. The author is grateful to Sebastian Edwards for his guidance and encouragement. The author also benefited from discussions with Sharon Kozicki, Monika Piazzesi, Lee Ohanian and Carlos Végh, as well as seminar participants at the Economics Department of UCLA, the Economic Research Department of the Federal Reserve Bank of Kansas City, and at the 8th Annual Meeting of LACEA. The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Meirelles Aurelio email:  marcela.meirelles.aurelio@kc.frb.org

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