Fiscal Policy Rules in Practice



1 Introduction

1.1 Motivation

The econometric evaluation of monetary policy with the help of simple policy rules has been
subject of extensive research in recent years. This research has shown that monetary policy
under discretion is suboptimal compared to a rule-based policy behavior. As a consequence of
this strand of research monetary policy has substantially changed over the last three decades.
Interest rate decisions of central banks have generally become more explicit and systematic.

In opposition to monetary policy rules, fiscal policy rules have received much less scrutiny in
economics. Nonetheless, the design and performance of different fiscal policy rules remains an
important element of macroeconomic policy analysis for a variety of reasons. One particular
reason is that recent literature has discovered a link between fiscal policy and the price level.
The relevance of this link between fiscal policy and prices depends crucially on the design of the
policy rule.

This paper analyzes German and Spanish fiscal policy. Thereby, the principal objective of this
paper is to investigate fiscal policy empirically in these two countries using simple policy rules.
We choose Germany and Spain, as both are Member States in the European Monetary Union
(EMU) and underwent considerable increases in public debt outstanding, particularly in the early
1990s. While other studies such as Taylor (2000) focus on the role of automatic stabilizers in
fiscal policy behavior, we want to highlight the link between public debt and fiscal instruments.
In particular, we want to answer the question, how fiscal policy behaves under rising public debt
ratios.

It is found that both Germany and Spain generally exhibit a positive relationship between
government revenues and debt. Using Markov-switching techniques, we show that both countries
underwent a change in policy behavior in the light of rising debt/output ratios at the end of the
1990s. Interestingly, this change in policy behavior differs in its characteristics across the two
countries and seems to be non-permanent in the case of Germany.

1.2 Literature Review

In 1993 John B. Taylor proposed a simple monetary policy rule linking the instrument of the
central bank, i.e. interest rates, positively to inflation and output deviations. Since then this so-
called Taylor rule has attracted a lot of attention. One reason for the popularity of Taylor rules
is obviously their simple form and their potential to differentiate between discretionary and rule-
based policy behavior easily. In this sense Taylor rules may serve as a benchmark for monetary
policy evaluation. Unfortunately, they do not allow for any statements in terms of optimality, as
they are ad-hoc and not derived from any welfare-theoretic considerations. What is also often
criticized is the fact that a central bank with dozens of well-trained economists is unlikely to
follow a simple decision rule such as proposed by Taylor (1993). Actually, central banks have
developed complex decision processes based on numerous variables. They make considerable



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