Increasing public investment can be an effective policy in bad times: Evidence from emerging EU economies

Abstract

Using Local projections and a Panel Structural Vector Auto-Regressive model, we evaluate the effectiveness of fiscal policy in the Central and East European EU economies. We find that an increase in public investment has a strong positive effect on output, employment, wages and consumption during periods of economic downturn. Deficit-financed public investment does not increase the debt-to-GDP ratio and is essentially self-financed. In contrast, an increase in public consumption has little impact on economic activity and increases the debt-to-GDP ratio. The observed short term effects concur with a neo-Keynesian pattern suggesting that increase in public investment boosts the demand for labor in the private sector, leading to higher real wages and higher consumption. In the medium term, an increase in public investment enhances private investment thus generating supply side effect. We conclude that public investment can be an important policy instrument for combatting recessions and stimulating long-run growth, since monetary policy has run out of steam.