*RYHUQPHQW
The assumptions about government behaviour are rather conventional. Governments do not
maximize an objective function but follow an exogenously given spending pattern. Current
expenditure is divided into interest payments on government debt LW%W, purchases of goods
and services *W (which includes government investment), government employment :W1*W,
net government transfers to households 75+W net of unemployment benefits %(1W and other
transfers 275W. Government spending is financed through labour income taxes 7/W and
social security contributions 6&W, corporate income taxes 7&W, energy taxes 7(W, value
added tax 9$7W and other receipts 5W
∆% = = LtBt + 3&,*, + :, N*, + BENt + TRH1 + OTRt - (T/, + SCt + TCt + TEt + 9$T, + Rt )
(15)
It is well known that public debt dynamics is an intrinsically unstable process provided the
real interest rate exceeds the average growth rate of the economy and both spending and
taxation grow in a fixed proportion with GDP. Dynamic consistency therefore requires the
introduction of a debt rule which makes one or several spending or receipt categories of the
government budget an instrument for debt stabilisation. To enforce the government’s
intertemporal budget constraint, the following fiscal policy reaction function is imposed
TR+l = TR+-ι + ψι * [(B/Г∖ - (B∕<)]+ ψ2. * [(B∕<) - (B∕<) ι ]
(16)
where (B∣<) is the target for the debt to GDP ratio. As a standard setting this rule is
imposed for net government transfers to households, 75+, which is least distortionary in the
model, but it can also be applied to other receipt or spending categories. Depending on the
size of the parameters ψ the government will respond to a deviation of the debt to GDP ratio
from its target level by an adjustment of the transfer payments to households. The debt rule
is similar in design to those imposed in many other macro models, as reviewed in Church HW
al. (1996). The parameters ψ and ψ, , 0.01 and 0.2 respectively, are chosen so that the
debt reduction is phased in over time in such a way that the reduction in government
spending is not accompanied by a sizeable increase in net transfers in the short run.
Total output is adjusted to include government wages into the definition of total GDP for
consistency with the national accounts
G'3t = < + :,n*,
(17)
where < is output, : government wages and N* government employment.
10