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Abstract
The domestic and international transmission mechanism of fiscal policy shocks are analysed in the United States and in Germany. Using a Bayesian VAR approach, we find that in both of these countries a fiscal expansion is associated with increases in output as well as in private consumption and investment. The terms of trade, which affect the international transmission of fiscal policy shocks, depreciate in response to a fiscal expansion, thus transferring some of the increased domestic purchasing power abroad. A US government spending shock is expansionary for all non-US G7 members. A German government spending shock is expansionary for most, but not all European economies, both within and outside the euro area. The dynamics of the BVAR can be rationalised using a dynamic stochastic general equilibrium model where heterogeneous households and firms face borrowing constraints.
Highlights
Is government spending an effective macroeconomic stabilisation tool? While Great Recession reignited the debate on this issue and stimulated a large amount of research, the current pandemic has led to unprecedented fiscal measures, amounting to almost 12 percent of global GDP (IMF, 2020)
To analyse the transmission mechanism of a government spending shock originating in Germany, we look at responses of output and the bilateral real exchange rate of the 10 biggest EA economies and 5 non-Euro Area economies
As we show in Appendix A, most of the features included in the model – such as habits, the presence of non-Ricardian households, price and wage stickiness – are essential if the model is to have any success in capturing the key dynamics in the data following a government spending shock
Summary
Is government spending an effective macroeconomic stabilisation tool? While Great Recession reignited the debate on this issue and stimulated a large amount of research, the current pandemic has led to unprecedented fiscal measures, amounting to almost 12 percent of global GDP (IMF, 2020). An unexpected increase in US government consumption causes the US terms of trade and effective real exchange rate to depreciate. It is associated with an increase in domestic GDP in the other G7 economies and with a bilateral real appreciation vis-a-vis the US dollar everywhere except Japan. We analyse a two-country DSGE model with nominal rigidities in the goods and labour markets, where households are divided into those with and without access to financial markets and where entrepreneurs face a constraint on their borrowing Such a model, by construction, is able to generate a positive response of both consumption and investment to a government spending shock.
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