The Effect of Financial Sector Size on Fiscal Multipliers

Abstract

This paper examines whether the effect of fiscal policy on output depends on the size of the financial sector. We find that this relation depends on the level of economic development. In developing countries, fiscal multipliers are higher when the financial sector is larger. The opposite is true for high-income countries. When financial sectors in high income countries exceed the 80-100% of GDP threshold we observe that fiscal multipliers are lower than when financial sectors are small. This implies that governments in high-income countries have less traction on the real economy when the financial economy is too (i.e., higher than the threshold of 80%-100% of GDP). Fiscal multipliers are estimated by the structural vector autoregression (SVAR) approach introduced by the paper of Blanchard and Perotti (2002) using the novel quarterly dataset of government expenditure compiled by Ilzetzki et al (2013). In terms of the trade-off between government consumption and investment, government consumption is the preferred fiscal instrument in countries with a large financial sector as it shows higher fiscal multipliers. Conversely, in countries with a small financial sector government investment seems to be the preferred fiscal instrument irrespective of the level of development of the country.