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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 flScal 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 fmancial market dynamics or on flScal 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. 1. 1 Motivation Fiscal policy and financial market reactions are increasingly receiving world­ wide attention. The most recent examples are the Maastricht criteria about flScal control, the South-East Asia financial crisis and the resulting IMF policy stance, the high level of public debt in developed and developing countries and the effect on interest rates and economic growth. In contrast to the still underdeveloped theoretical literature on these dynamic links, finding empirical evidence that supports the existence of these links is not a very hard task.

Inhaltsverzeichnis

Frontmatter

1. Introduction

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.
Roland Demmel

2. The basic deterministic macroeconomic model

Abstract
The main purpose of this chapter is to build and explore a benchmark macro-model in a deterministic setting of financial markets. Although this model exhibits highly unrealistic features like a constant short-term interest rate and thus a flat term structure of interest rates, it has nevertheless some merits: first of all, the income and debt dynamics are linear so that we can calculate and analyze the time paths of these variables explicitly. This delivers clear-cut results with regard to economic growth and public indebtedness. Second, the stochastic macro-model to be developed later on converges to this deterministic version when risk disappears. We can check the correctness of the reduced-form dynamics of our stochastic model by simply looking at the deterministic model. Third, by comparing the outcomes of the stochastic version with the deterministic one, we can discern the qualitative effects brought about by the introduction of risk.
Roland Demmel

3. The basic stochastic macroeconomic model and the short-term interest rate dynamics

Abstract
In this chapter, we will develop a stochastic analogue to the dynamic macroeconomic model already discussed in the last chapter. This is accomplished by modeling the economy’s technology not as a fixed parameter, but as a certain continuous-time stochastic process. As a consequence, holding capital involves the bearing of risk. The intertemporal consumption/asset allocation problem of the private households becomes risky. This risky decision-making reflects the reality of how financial markets form their behavioral rules much better than the deterministic model in the previous chapter. Hence, we can expect our model to ‘produce’ prices for assets traded on the financial market that will generally not be constant but change dynamically as it happens in reality. Specifically, interest rates will no longer be equal to the net return on capital but rather react on changes in the economy, especially on fiscal policy changes. The link between fiscal policy and the term structure of interest rates is a new aspect of this model. In equilibrium, the model in this chapter will produce nonlinear, stochastic dynamics describing the evolution of output, capital, private wealth and public debt. For this reason, this chapter lays the basis for the analysis of all interesting economic aspects to be discussed in subsequent chapters: the relationship between fiscal policy and the term structure of interest rates, the question how economic growth is affected by the financial market, and the dynamics of public debt in the light of stochastically varying interest rates.
Roland Demmel

4. Term structure of interest rates and fiscal policy

Abstract
As already mentioned in great detail in Chapter 1, the whole mathematical finance literature dealing with the term structure of interest rates has abstracted from studying the influence of fiscal policy on the term structure. Usually, arbitrary stochastic dynamics for a given set of ‘factors’1 driving the term structure were introduced by postulating specific forms of diffusion processes representing the evolution of these factors. As a consequence of these ad-hoc approaches, the influence of fiscal policy was either completely neglected or introduced in an ad-hoc way, at best 2. One can, of course, argue that the influence of fiscal policy is already integrated in the factor dynamics used, namely in the way the dynamics are parametrized. This implies that these parameters are seemingly policy invariant. When one argues that the influence of fiscal policy is already embedded in such arbitrary parameters with almost no economic meaning, then estimating these models is subject to criticism similar to the well-known ‘Lucas Critique’ 3. As the respective introductory remarks in Chapter 1 should have made clear, we think that fiscal policy does matter for term structure considerations. We will now discuss the term structure of interest rate and the influence of fiscal policy in the macroeconomic setting laid down in the previous chapter.
Roland Demmel

5. Economic growth and fiscal policy

Abstract
Having explicitly examined the influence of fiscal policy on short-term interest rate dynamics and the term structure of interest rates in the last two chapters, we now want to turn to the second main question to be addressed within our model: how do fiscal policy and financial market interactions influence the evolution of output, income and hence economic growth? Since we already mentioned in Chapter 3 that our production function is known to produce endogenous growth, the question here is not whether growth reaches a steady state or not. The question is rather: does the interaction between interest rate dynamics and fiscal policy imply positive or negative growth rates in average? And are growth rates accelerating like in the deterministic setting (which did not automatically imply that they are positive)? Recalling the discussion in the introductory chapter, it is our aim to show that growth does not evolve independent of financial markets and fiscal policy settings.
Roland Demmel

6. Public debt dynamics

Abstract
In this chapter, we will address the last economic question resulting from the chosen model framework: how does public indebtedness evolve and how does fiscal policy and financial market interaction influence this evolution? We will take ‘public debt per output’ (i.e. the debt ratio) as the appropriate measure for public indebtedness. The debt ratio is usually associated with the question whether a present stock of public debt is compatible with default-free future debt service which would guarantee intertemporal solvency of the government. This solvency question itself does, however, not stand in the foreground of this chapter. The reason is that we always assume that the tax rate and the public expenditure ratio are subject to those fiscal policy constraints developed in Chapter 3. These conditions were shown to fulfill the transversality condition, thereby ruling out Ponzi-game dynamics of public debt as pointed out by Obstfeld/Rogoff (1996, p. 717) 1. Thus, the main purpose in this chapter is to analyze the model dynamics of the debt ratio, especially with regard to the underlying parameters and variables characterizing fiscal policy and financial market behavior.
Roland Demmel

7. Summary, conclusions and outlook on future research

Abstract
In this thesis, we have studied the interaction of fiscal policy and financial market behavior in a dynamic general equilibrium model of a real, closed economy. Output was produced via a linear production function with capital as sole input. The private sector was introduced as a representative household solving its intertemporal consumption and saving/investment problem subject to its dynamic budget constraint. The structure of the financial market was characterized by the exogenously given types of assets: capital, short-term government bonds, private sector bonds of free maturity. The public sector was described by exogenously given rules regarding taxation and public spending. Resulting fiscal deficits drive public debt. Public debt appears only in form of short-term government bonds. In case public debt happens to be negative, this is equivalent to the government being in a creditor position relative to the private sector.
Roland Demmel

Backmatter

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