Abstract

Fiscal Policy and Nonlinear Interest Rate Dynamics in Continous-Time Stochastic General Equilibrium

Dr. Roland Demmel
Asset Liability Manager

ARAG Lebensversicherung, Muenchen

In this paper, we examine the dynamic interaction between fiscal policy and financial markets. Our framework is a continuous-time macroeconomic growth model with a private and a public sector. A homogeneous good is produced according to a linear-stochastic production function, a representative household solves its intertemporal optimization problem having access to different kinds of assets and fiscal policy is introduced by specifying rules concerning taxation, public expenditure and the financing of endogenous deficits. In general equilibrium, asset price and accumulation processes are determined and the dynamics of the short-term interest rate is derived as a nonlinear stochastic differential equation. Subsequently, we analyze the boundary behavior of this diffusion process and derive constraints on fiscal policy so that the transversality condition holds and the economy remains viable everywhere almost surely. Using these constraints, the interest rate dynamics are shown to possess properties like mean-reversion and heteroskedasticity that are highly desirable in terms of observed market data. Finally, we analyze and interpret short- and long-run effects of fiscal policy on the interest rate dynamics. Our general finding is that feedback effects between fiscal policy and financial markets exist which generate the nonlinear interest rate dynamics in our stochastic environment of financial markets.