Deficit Targeting Strategies: Fiscal Consolidation and the Probability Distribution of Deficits under the Stability Pact

Using stochastic simulations, this article analyses the probability distribution of a country's deficit ratio under fixed exchange rates and a variety of monetary and fiscal policy rules. The purpose is to show how the probability of an ‘excessive deficit’, defined by Europe's Stability Pact as a deficit to GDP ratio above 3 per cent, varies with different deficit targets and policy rules. Using a macro model, we find that when subject to historically consistent shocks, these fiscal ratios typically have a wide distribution, with fat tails and significantly longer tails on the upper side. That means fiscal targets may have to be country‐specific and conservative, and that fiscal policy has to be forward‐looking to keep the probability of excessive deficits below acceptable limits.