Impact of Fiscal Policy on Consumption and Labor Supply under a Time-Varying Structural VAR Model

Shaheen Shaheen

doi:10.3390/economies7020057

Abstract

This paper investigates the impact of fiscal policy on private consumption and labor supply in the UK economy using time-varying parameter vector autoregression (TVP-VAR) with stochastic volatility for the period Q2 1987 to Q2 2017. It considers fiscal variables such as government expenditure and net tax revenue and evaluates their impact on private consumption and average hours worked per week. Three sample periods were selected and two approaches were used to identify impulse responses, first taking the average of stochastic volatility over the sample period, and then allowing for sign restrictions based on contemporaneous relationships among the selected variables. The study found a negative wealth effect of public spending on private consumption and a positive effect on hours worked, as people tend to work more hours to maintain the same standard of living. Similarly, a tax shock generates negative effects on consumption but the impact on worked hours remains unclear over a three-year time horizon. These findings are almost consistent across sample periods and alternative specifications of impulse responses. This is one of only a few studies to determine the linkages between fiscal policy and the labor market using a macroeconomic framework.

Highlights

The Great Recession of 2008 revived interest in the role of fiscal policy, and there has been an increase of studies in the literature evaluating the stabilizing role of government spending and taxes, especially in the context of ineffective monetary policy due to the zero lower bound on nominal interest rates
This study employs a time-varying modelof with stochastic consumption and varying elasticity of the labor supply. Under both types of schemes, a positive tax to examine the impact of fiscal policy on private consumption and labor supply. This model allows shock leads tothe lower private consumption, whereas when we consider average stochastic volatility us to capture uncertainty and drift of parameters at each time point in the sample, as most of the generating impulse responses at that time, it shows varying effects on the elasticity of the labor macroeconomic dynamic structures are characterized by volatility and fluctuations
This study finds a short-term “negative wealth” or “crowding out” effect of government expenditure on private consumption and a positive effect on hours worked

Summary

Introduction

The Great Recession of 2008 revived interest in the role of fiscal policy, and there has been an increase of studies in the literature evaluating the stabilizing role of government spending and taxes, especially in the context of ineffective monetary policy due to the zero lower bound on nominal interest rates. In response to the onset of the recession, many countries adopted fiscal stimulus programs to boost aggregate demand. The government was constrained in its pursuit of fiscal stimulus because of the huge bank bailouts made necessary by the banking crisis. These led to an immense burden on public finance and debt rose to 80% of gross domestic product (GDP). This study aims to investigate the impact of these fiscal policies on consumption and labor supply in the UK economy during this period

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