Michael Dotsey and Ching-Sheng Mao
This paper studies the effects of fiscal policies--depicted as stochastic changes in government spending and distortionary tax rates--when the government is constrained from using lump sum taxes for achieving intertemporal budget balance. The ratio of debt to gnp, therefore, has consequences for the future choices of government spending and distortionary taxation and hence affects real economic activity. Further modeling fiscal policy in this way generates results that differ substantially from those in standard stochastic models where lump sum taxes are used for budget balance. The modeling of fiscal policy presented here is also consistent with empirical evidence on U.S. fiscal policy.