In the Alesina-Tabellini model, a government budget deficit bias arises because the government aims to stimulate output

above the natural rate of output. True or false? Explain.

False. The key result of the Alesina-Tabellini model states that, instead of aiming to stimulate output above the natural rate
as suggested by the question, the incumbent political party strategically overspends on its desired public good to constrain
opposing party if not re-elected. Here is how the result can be derived:

Assumptions:
 Two political parties, L and R, with different preferences over public goods G L and GR, with utility UL (GL, GR) = ln GL
and UR (GL, GR) = ln GR respectively so party L only cares about GL and party R only cares about GR.
 Incumbent party I in period 1 maximizes I, where is the intertemporal discount
∈ { L, R } I I
V =ln G1 + βρ lnG2 β ∈ {0 , 1 }
factor, and ρ ∈ [ 0 , 1¿ is the probability of re-election in period 2.
 Government constraint （assuming no initial debt and r=0）:
G1=τ Y 1 + D
G2 + D=τ Y 2
Where L R, with exogenous income tax rate τ ∈ (0, 1), exogenous national income in period t, with ≥ Y1,
Gt =Gt +Gt Yt Y2

and period 1 government budget deficit and debt level D, which is repaid in period 2.

Derivation:
Using budget constraints I O and I O , where GO denotes public good preferred by other
G1 +G1 =τ Y 1+ D G2 +G2 + D=τ Y 2
party, incumbent party I ∈ {L, R} in period 1 maximizes:

Since
∂ V <0, the incumbent will set O so for both periods
I
I
O GT =0 Gt =Gt
∂ GT
Hence
Derive wrt D:
Rearranging:

Therefore,

Consequently, we can see that as ρ increases, D decreases and vice versa.

Therefore, the government budget deficit bias increases when the probability of re-election decreases as the government
overspends strategically on its desired public good to constrain opposing party if they’re not re-elected.
Summarize the main features of the current UK fiscal policy framework and provide a key drawback of its current fiscal
mandate.

Main Features of the current UK fiscal policy framework:

Charter for Budget Responsibility (since 2011)

Fiscal Rules:
 Fiscal policy ‘mandate’ will specify the near-term fiscal deficit target
(1) 2011-2015: forward-looking target to achieve cyclically-adjusted current balance by the end of a rolling 5-year forecast
period.

Current budget balance: difference between all revenue received by public sector and ‘current spending’ by public
sector, which excludes net investment

Cyclically-adjusted (or ‘structural’) deficit: adjusted to reflect estimated impact of economic cycle (i.e. for zero output
gap)

(2) 2015-2016: target for surplus on public sector net borrowing in each subsequent year (in normal times, which clearly
excludes the occurrence of Covid-19)

(3) Since Autumn 2016: target to reduce cyclically-adjusted public sector net borrowing to below 2% of GDP by 2020-
2021

 Fiscal policy objective: return public finances (public sector net borrowing) to balance at earliest possible date in next
Parliament (2020-2025 at time of announcement)

Office for Budget Responsibility:

Official independent UK fiscal policy watch dog since 2010:
 Examines and reports on sustainability of public finances
 Provides forecasts for Government’s annual Budget Report and assesses the likelihood of achievement fiscal rules

A key drawback of the current fiscal mandate:

 Some of the definitions are deliberately vague: the ‘rolling 5-year forecast period’ to achieve cyclically-adjusted current
balance, for example, you can always push the target five years forward without actually achieving it. Furthermore, the
cyclically-adjusted current balance is also subject to interpretation and arbitrary definition by politicians as to the length
of an economic cycle.