# Introduction

- 108 Downloads

## Abstract

The introduction of the thesis consists of four parts: first, we motivate our chosen macroeconomic setting by looking at some real world phenomena. For a better understanding of these phenomena, we argue that the mutual dynamic interactions between fiscal policy and financial markets need to be closely examined in a macroeconomic framework. Second, we review different strands of the economic literature in order to show that most of the literature has so far exclusively concentrated either on financial market dynamics or on fiscal policy issues. We conclude that a more integrated model setting is called for in order to explain the dynamic interactions observed in reality. Third, we discuss at length the economic assumptions underlying our model. This avoids multiple repetition later on. Finally, we outline the structure of the thesis and the objectives we pursue in the different chapters.

## Keywords

Interest Rate Financial Market Fiscal Policy Term Structure Yield Curve## Preview

Unable to display preview. Download preview PDF.

## Notes

- 1.See Appendix 1.1 for the corresponding data of selected European countries.Google Scholar
- 2.Appendix 1.2 contains the respective real yield curves in monthly frequency during 1980.Google Scholar
- 3.We are aware of the fact that, in October 1979, the new chairman of the Fed, Paul Volcker, began to change US monetary policy by replacing the old interest rate target with a new money supply target. This policy change already induced lower inflation rates during the considered year and may have also been influential for the real yield curve, possibly via existing covariances between nominal and real financial market variables.Google Scholar
- 4.For an analysis of the term structure on Russian bond markets, see Schöbel/Yakovlev (1996).Google Scholar
- 5.Another frequently cited externality is a general increase in interest rates due to excessive deficits. Buiter/Corsetti/Roubini (1993) object by pointing on the ‘pecuniary externality’ aspect of an interest rate increase: in their view, the interest rate increase simply constitutes a relative price adjustment on a perfectly competitive financial market.Google Scholar
- 6.Art. 104 forbids a monetary bailout by the ECB, Art. 104b forbids a fiscal bailout by the EU, i.e. the member states.Google Scholar
- 7.The underlying reasoning could be the following: consider a member country (or a coalition of member countries) that decides to default on its debt due to unsustainable fiscal policy. Any bank holding a significant part of its portfolio in bonds of this government could go bankrupt. Via a systemic crisis, the whole financial system could break down. Faced with the costs of such a breakdown, it would not be time consistent for the remaining governments to stick to the no-bailout rules. Anticipating this, financial markets are unlikely to sanction unsound fiscal performance in the first place. This, in turn, reduces the costs of pursuing unsound fiscal policies. For a complete and detailed discussion of these issues, see Holzmann/Hervé/Demmel (1996).Google Scholar
- 8.We emphasize that the following literature review is far from being complete but represents just the main achievements as we see them.Google Scholar
- 9.This long time range can certainly be better understood when one recalls that during that time the economic problems caused by World War I and its aftermath as well as the question of unemployment and hyperinflation linked to the Great Depression stood high on the agenda of economists thereby leaving less time and interest to other questions.Google Scholar
- 10.Burton G. Malkiel (1989, pp. 265, line 1–3) defines what term structure of interest rates is all about: „The term structure of interest rates concerns the relationship among the yields of default-free securities that differ only with respect to their term to maturity. The relationship is more popularly known as the shape of the yield curve...“. In this spirit, we will further use ‘term structuré of interest rates’ and ‘yield curve’ synonymously to denote the same concept: the time to maturity dependency of interest rates.Google Scholar
- 11.The importance of the work of Black, Scholes and Merton became finally visible when the latter two were awarded the Nobel Price in Economics in 1997. The reason why Fischer Black was not honored is that he died in 1995 and Nobel prices are usually not awarded posthumously (the only exemption so far has been the Secretary General of the U.N., Dag Hammarskjöld, in 1961).Google Scholar
- 12.This ‘market price of risk’ appears in the valuation equation since the ‘underlying assets’, short-and long-term interest rate, are not tradable per definition. In the Black/Scholes framework the underlying asset, the stock, is tradable so that no ‘market price of risk’ term is involved in their valuation equation.Google Scholar
- 13.For a detailed overview as well as a criticism of this approach, see Vetzal (1994).Google Scholar
- 14.According to Romer (1996, p. 67), „The relevant question, however, is not whether it (Ricardian equivalence) is exactly correct, but whether there are large departures from it.“ Judd (1987, p. 51) discusses possible departures from Ricardian equivalence by extending Barro’s model to a continuous-time deterministic setting and reaches the conclusion: „Hence, the impact of debt is an empirical issue and Ricardian neutrality appears to be a reasonable benchmark.“ Thus, Ricardian equivalence should be seen as a theoretical benchmark but it is certainly not a strict paradigm.Google Scholar
- 15.For example, a country’s constitution could be thought of being such a device. For a detailed discussion of the subject, see Persson/Tabellini (1990).Google Scholar
- 16.A minor problem is that a very advanced soft-and hardware equipment is needed in order to estimate the model dynamics.Google Scholar
- 17.Doing so poses the basic question: should one use discrete or continuous time to formulate macroeconomic models? Proponents of discrete time models have often argued that nature evolves on a discrete time scale. Even more important is their argument that individuals as the subjects of any economy receive and operate information in discrete time and not continuously. Their conclusion is that models should be formulated in discrete time. We agree to the extent that the models should then use the ‘natural time unit of individual information processing’ as the proper distance between discrete time points. Although nobody seems to know what the appropriate time unit of human information processing is, most people would agree that such a natural time unit lies certainly in the range of seconds instead of days, weeks, months or even years. Continuous-time modeling is hence certainly a better approximation of reality than using monthly or longer time units in discrete-time modeling.Google Scholar
- 18.Doing so is additionally in the tradition of term structure modeling in mathematical finance.Google Scholar
- 19.One should, however, emphasize that the Auerbach/Kotlikoff framework is highly recommendable in case one wants to do simulations in order to study dynamic behavior of macroeconomic variables. A recent successful demonstration of the strength of this framework is Altig et al. (1997).Google Scholar
- 20.If, however, one recognizes that taxes on labor income play an important role for the overall amount of tax revenues in most countries, then it becomes clear that the labor-leisure choice should be included in future work in order to get a better ‘picture’ of taxation and dynamic composition of public deficits.Google Scholar
- 21.As Kydland/Prescott (1982) point out, this assumption is an unpleasant one when one wants to tackle the problem of matching observed business cycle data with model-generated data. Since this is not our main concern here, we abstract from the fact that in reality investment decisions need time to add to the existing capital stock.Google Scholar
- 22.We note that the stock of public bonds can also become negative. In such a case (for example, in Chapter 2), the government is a creditor to the private sector.Google Scholar
- 23.Of course, the question is whether we should not introduce lump-sum taxation, especially since this form of taxation is known to be welfare-superior to all other tax rules. The answer is that distortionary taxation reflects reality much better than lump-sum taxation. An example for the practical difficulty to introduce lump-sum taxes goes back to the 1980s in the United Kingdom. Prime Minister Margaret Thatcher tried to introduce a lump-sum tax called ‘poll tax’ and failed owing to the ‘pressure of the street’ although she had a comfortable majority in parliament. This is clear evidence that the introduction of lump-sum taxes in a democracy is hard to push through. It is particularly true when there are large groups of the people having strong preferences for’ social justice’. Such distributional aspects are neglected by lump-sum taxes.Google Scholar
- 24.Taxes on stocks like wealth are less frequently found in literature although they are part of many countries tax code. The reason for this is that they constitute only a small share of tax revenues compared to the taxes on flows.Google Scholar
- 25.This is not per se harmful since Ricardian equivalence is still hotly debated among economists as we have already mentioned in section 1.2.2. We therefore view our departure from Ricardian equivalence as justified since the theoretical analysis will yield important insights in how far fiscal policy impacts on the economy in our model.Google Scholar
- 26.When we talk about government expenditure now or later, then we always mean all public expenditure except for interest payments, i.e. primary expenditure.Google Scholar
- 27.See Appendix 1.3 for the relevant time series data of government consumption ratios for France, Germany, Luxembourg and the United Kingdom from 1980-1989.Google Scholar
- 28.Examples for the literature that views government expenditure as either productive input or utility-enhancing ‘good’ for the private households are Aschauer (1988), Aschauer/Greenwood (1985), Barro (1981, 1989, 1990), Barro/King (1984), Baxter/King (1993), Turnovsky/Fisher (1995) and Hervé (1998). See also Turnovsky (1995, chapter 9 and 13) for a general discussion of the motives for the different assumptions made about government expenditure in dynamic macroeconomic models.Google Scholar
- 29.One economic justification for allowing only short-term government bonds could be an inherent distrust of the private sector concerning the soundness of fiscal policy. Thus, the private sector is only willing to lend its resources for extremely small amounts of time in order to be able to get them back as early as possible to decide then again what to do next with the resources. Such a situation happened, for example, in Italy in the early 1980s when average time to maturity of public debt shrunk from a usual value of six years to hardly one year (see Dornbusch/Draghi (1991) and therein especially Alesina/Prati/Tabellini (1991)).Google Scholar
- 30.We are well aware of the fact that the IFS data in contrast to the GFS data use the central government concept instead of the general government. However, in the case of Luxembourg both concepts almost coincide so that comparability of Luxembourg’s debt data with the general government debt data of the three other countries is guaranteed.Google Scholar