Fiscal solvency and fiscal policy

This paper addresses the issues of the sustainability of government debt stocks, and analyses how this important topic has been handled in the construction and use of large, empirically based, macromodels. It argues that governments must be solvent in a forward looking model, for a theoretically coherent model to contain an equilibrium saddlepath.The implementation of solvency rules in several widely used models of the world economy is discussed. A simple costs of adjustment model is constructed to illustrate the various short-term pay-offs facing a government in choosing a solvency rule. It is also argued that these rules must be robust to changes in the economic environment and it is shown how one particular rule achieves this.

The implementation of the solvency or tax rule may have a significant effect on perceived model properties and the consequent policy advice offered by economists who use such models. This is illustrated by comparing the IMF's MULTIMOD and NIGEM's tax rule on the same model.

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