Automatic stabilizers, fiscal rules and macroeconomic stability

This paper analyzes the effect of the fiscal structure upon the trade-off between inflation and output stabilization induced by technological shocks in a DGE model with nominal and real rigidities that also integrates a rich menu of fiscal variables as well as a target on the debt to output ratio. The channels through which fiscal policy affects macroeconomic stability include supply-side effects of distortionary taxes, the procyclical behavior of public spending induced by fiscal rules and the conventional effect of automatic stabilizers operating through disposable (permanent) income. The paper investigates these channels and concludes that, contrary to what has been found in RBC models, distortionary taxes tend to reduce output volatility relative to lump-sum taxes when significant rigidities are present. We also study the stabilization effect of alternative (distortionary) tax structures and find that these are only relevant if substantial rigidities are present. (c) 2005 Elsevier B.V. All rights reserved.