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Department of Economics Seminar with Dr Alfred Duncan, University of Kent Prudential Fiscal Stimulus
When government fiscal interventions are predictable, private incentives are distorted. If firms anticipate fiscal stimulus in a crisis, then they might take on excessive risk today. How can fiscal interventions be designed to mitigate such moral hazard problems? And would such interventions be time consistent? We show that fiscal stimulus programmes can be designed to induce precautionary behaviour ex ante from firms, and we label these programmes prudential fiscal stimulus. We demonstrate the theory with a wage subsidy stimulus policy. We show that countercyclical wage subsidies can be welfare improving even in the absence of aggregate demand or labour market externalities. Prudential fiscal stimulus is time inconsistent, but the presence of aggregate demand externalities can bring discretionary policies closer to optimal policies.