The Effects of Fiscal Policy in New Zealand: Evidence from a VAR Model with Debt Constraints

Tugrul Vehbi,Oscar Parkyn

doi:10.1111/1475-4932.12116

Abstract

This article investigates the macroeconomic effects of fiscal policy in New Zealand using a structural vector autoregression (SVAR) model. The model is the five‐variable SVAR framework proposed by Perotti (2005), further augmented to allow for the possibility that taxes, spending and interest rates might respond to the level of the debt over time. We examine the dynamic responses of output, inflation and the interest rate to changes in government spending and revenues and analyse the contribution of shocks to New Zealand's business cycle for the period 1983:1–2010:2. We find that the effects of government expenditure shocks in New Zealand appear to be positive but small in the short run at the cost of higher interest rates and lower output in the medium to long run. The sign of the effects of tax policy changes are less clear‐cut, but again the effects on GDP appear similarly modest. Past fiscal policy is analysed through a historical decomposition of the shocks in the model. This suggests that discretionary fiscal policy has had a generally pro‐cyclical impact on GDP over the past 15 years, and a material impact on the real long‐term interest rate. A fiscal expansion has a positive but limited impact on inflation.

Highlights

The long-standing debate among economists about the effectiveness of fiscal policy as a counter-cyclical tool has spawned a large literature about the size of fiscal multipliers
The model included the government’s long-term interest rate, which is likely to be an important variable in the wider economy linked to the cost of capital of firms and the borrowing rate for households
3 The results show that the fiscal multipliers from changes in government spending in New Zealand appear to be positive but small in the short-run, at the cost of higher interest rates and lower output in the medium to long-run

Summary

Introduction

The long-standing debate among economists about the effectiveness of fiscal policy as a counter-cyclical tool has spawned a large literature about the size of fiscal multipliers. On a more general and technical note, Pagan et al (2008) emphasise the possible pitfalls of excluding a stock variable in a VAR specification They show that such an omission introduces non-invertible moving average terms into the model, meaning that the structural VAR (SVAR) representation of the system fails to exist. Using the methodology outlined in FG, we allow for the possibility that taxes, spending and interest rates might respond to the level of debt over time This is implemented by enriching the model dynamics to include two additional variables: the long-term interest rates and inflation as well as including the government’s intertemporal budget constraint as an identity.

The rationale for including the IGBC

Model and data

Elasticities of government revenues and expenditures

Data and estimation

Empirical results

Interpreting the fiscal shocks

Impulse response functions

Government spending shock

Government revenue shocks

Interpreting the fiscal multipliers

Quarters

Fiscal policy and the business cycle