Policy Lag and Sustained Growth

Abstract

This study provides a theoretical analysis of economic stability when a fiscal policy lag and sustained economic growth coexist. We develop a New Keynesian model by introducing economic growth based on an exogenous factor and a fiscal policy rule with a delay in policy reaction. We clarify the effect of these factors on economic stability by performing a dynamic analysis of the delay-differential equation system derived from the developed model. Our study has several contributions. First, this study contributes an analysis of the effect of a policy lag on stability. When the economy does not grow, a large policy lag destabilizes the economy. However, in a sustainably growing economy, a large policy lag may eliminate instability and contribute to economic stability. Second, we show that a change in the economic growth rate can affect economic stability under a policy lag. This new finding runs contrary to the usual results from growth models without a policy lag.