Automatic Stabilizers and Monetary Rules in a Ricardian Economy

We analyze the effect of the fiscal structure upon the trade-off between inflation and output stabilization in presence of technological shocks and deficit or debt objectives in a DGE model with nominal inertia. The model is calibrated to reproduce the main long-run and business cycle features of European economies, and it integrates a rich menu of fiscal variables, including fiscal rules. These rules are necessary to obtain a unique Ricardian equilibrium, but they also exemplify targets incorporated into most modern fiscal systems. In fact they represent these institutions in a very flexible way, since they allow for fairly large and long-lasting deviations of the debt to output ratio from its target. The main finding is that, for realistic calibrations of the model, distortionary taxes linked to economic activity, which are meant to provide the economy with automatic stabilizers, worsen the output-inflation variability trade-off as compared with an economy with lump-sum taxes. Aside from the well known supply side channels that explain this result, we find that fiscal rules, designed to ensure debt consolidation, induce cyclical movements in aggregate demand that also contribute to increase the volatility of output in presence of distortionary taxes.