private capital formation. Finally, it can be noticed that the government primary surplus-to-GDP ratio increases both in the short and the long run. The increase reaches a maximum of 5.6 percentage points over the reference path (Table 2, period 5), reflecting a sharp decline in government transfers to households. These transfers are squeezed due to the strong increase in the bond interest payments resulting from our assumption that bond financing is maintained at baserun levels, implying that (with exogenous foreign borrowing in foreigncurrency terms) the government deficit is given from “below the line.” It is worth noting that the magnitude of the long-run decline in GDP would of course be smaller if, as a result of a Taylor-type rule, the authorities were to lower interest rates in response to lower inflation. It is also interesting to note that this experiment, a disinflation attempt based on a rise in official interest rates, leads to a rise in the probability of default (essentially because the increase in interest rates has a contractionary effect, which translates into lower tax revenues), and an initial real depreciation (see Table 3). These results are consistent with those derived by Blanchard (2004) in a very different setting, characterized by a direct link between the probability of default, capital flows, and movements in the exchange rate. Nevertheless, our experiment carries a similar note of caution: in an inflation targeting framework (in which interest rates are used to achieve a specific level of inflation), an initial inflationary shock can have perverse effects. An increase in real interest rates to “choke off” inflationary pressures can lead to a real depreciation, and thus higher inflation, which may lead in turn to further increases in interest rates. In our experiment, fiscal policy is also an important potential tool to reduce inflation: by issuing less domestic debt and reducing the debt-to-tax ratio, the government would mitigate the increase in the probability of default, which would in turn dampen the rise in the bond rate. This would reduce pressure on cutting the primary deficit through a drop in transfers, thereby dampening the adverse effect on activity and tax revenues.
4.2
Fiscal Adjustment
As noted earlier, we discuss two types of fiscal adjustment policies: an increase in the VAT rate and a rise in the tax rate on income of profit earners.
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