Stochastic Characterisation of EMU Budget Discipline with Policy Uncertainty

With the recent debt crisis, the necessity of effective measures for safeguarding fiscal sustainability has become apparent, leading to an intense debate. Most of the debate focuses on restoring fiscal imbalances through strengthening fiscal rules. I address two issues impeding the success of these austerity measures: macroeconomic uncertainty and fiscal policy reaction. Specifically, I apply a structural VAR model to characterise the shocks to growth, inflation and interest rates. In combination with the estimation of fiscal reaction functions, this allows for the derivation of the distribution of fiscal realizations. More than previous studies, I model the volatility in fiscal policy. My results stress the importance of fiscal policy shocks relative to macroeconomic sources of uncertainty for the volatility in the debt evolution. This may impel the enforcement of stricter surveillance to hedge against disadvantageous outcomes.


*This research benefited from a stay at the National Bank of Belgium's research department on the occasion of its Trainee Programme for Young Researchers