Abstract
This paper describes an approach to making fiscal policy decisions based on probabilistic statements on the likely occurrence of events as specified in a rules‐based framework for making fiscal adjustments. The event probability forecasts are obtained from a simple time series econometric model of the key variables influencing debt dynamics (interest rates, output and debt itself). The approach is applied to data for ten developed countries for 1956–2016 and the analysis demonstrates the importance of accommodating international linkages in forecasting, noting that failure to do so would have led to excessive fiscal cutbacks and austerity in recent years.
Highlights
The Global Financial Crisis (GFC) and the subsequent European Sovereign Debt crisis highlighted the importance of cross-country interdependencies in financial markets, the interplay between countries’ monetary and fiscal policies and their crucial roles in determining macroeconomic performance
The rest of the paper is organised as follows: Section 2 describes the way in which models inform fiscal policy decisions and explains our proposed approach based on event probability forecasting; Section 3 describes our modelling exercise, explaining the Global Vector-Autoregressive (GVAR) and GVECM framework, describing the preferred forecasting model and presenting our analysis for the OECD10 over 1991-2016; and Section 4 concludes
We test the stationarity of the variables using the Cross-section Augmented Dickey-Fuller (CADF) unit root tests of Pesaran (2007) and the Cross-Section IPS (CIPS) panel unit root test described in Pesaran, Smith, and Yamagata (2013)
Summary
The Global Financial Crisis (GFC) and the subsequent European Sovereign Debt crisis highlighted the importance of cross-country interdependencies in financial markets, the interplay between countries’ monetary and fiscal policies and their crucial roles in determining macroeconomic performance. A potentially important element in the construction of the countries’ event probability forecasts is the role played by cross-country interactions because there are potentially many common, global factors including those underlying financial contagion - driving the key variables influencing debt dynamics in each country and many international feedbacks that propagate the effects of changes experienced in one country over time and across borders.5 For this reason, we estimate our probability forecasts using both nation-specific vector-autoregressive (VAR) models and Global Vector-Autoregressive (GVAR) and Global Vector Error-Correction (GVECM) models which can accommodate the effects of international linkages on forecasts of the key variables and on the forecast probability of the events motivating fiscal adjustments. The rest of the paper is organised as follows: Section 2 describes the way in which models inform fiscal policy decisions and explains our proposed approach based on event probability forecasting; Section 3 describes our modelling exercise, explaining the GVAR and GVECM framework, describing the preferred forecasting model and presenting our analysis for the OECD10 over 1991-2016; and Section 4 concludes
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