THE IMPACT OF FISCAL POLICY ON PROFITS

Abstract

I. INTRODUCTION A large number of policy-making decisions rely on the key issue of the impact of fiscal policy on the economy. Therefore, it is not surprising that the effect of fiscal policy on macroeconomic aggregates has been extensively studied in the empirical literature. (1) Several authors, starting with Blanchard and Perotti (2002), have attempted to estimate the effect of government spending shocks on output and other variables in the context of structural VAR models (see Perotti 2008 for a survey). This interest has been renewed since the 2008-2009 recession, given the unprecedented size of fiscal packages worldwide (Barro and Redlick 2009; Hall 2009). An important part of this literature focuses on the theoretical and empirical investigation of the fiscal policy transmission channels. Theories of fiscal policy transmission differ in their implications regarding the response of different macroeconomic variables to government spending shocks. For example, the neoclassical model predicts a negative impact of government spending on real wages and consumption, while this prediction is challenged by New Keynesian models. To that end, an important branch of empirical literature on fiscal multipliers has investigated the transmission channels of fiscal policy by looking mainly at the response of private consumption and real wages. (2) This paper deals with an important but relatively under-investigated channel of fiscal policy transmission, which is the effect of fiscal policy on profits. As pointed out by Hall (2009), the impact of fiscal shocks on the markup of price over marginal cost is important for understanding the functioning of the fiscal multiplier. In the purely neoclassical general-equilibrium model, a rise in government spending produces a negative wealth effect, the labor supply curve shifts outward and real wages and consumption fall. This implies that the output multiplier will be well below unity. A Keynesian type fiscal multiplier, implying a large positive output effect and positive responses of private consumption and real wages to increased government spending, relies on a negative response of the markup of price over marginal cost to an increase in economic activity. The intuition is that a decrease in the price-marginal cost markup in response to higher government spending allows a rise in wages or at least a smaller reduction in wages, compared with the case when the markup is constant. A rise in wages would then imply that households will substitute away from leisure and into consumption. Therefore, if the markup is countercyclical conditional on government spending shocks, sizeable output multipliers of fiscal spending are consistent with existing empirical evidence that fiscal shocks are not related to strong decreases in real wages or consumption (Blanchard and Perotti 2002; Fatas and Mihov 2001; Gall, David Lopez-Salid, and Valles 2007; Perotti 2005, 2008). In general, a New Keynesian model with sticky prices implies a countercyclical markup ratio, as input prices rise in a boom while output prices stay constant. However, for understanding the fiscal policy transmission, the key factor is markup and not price stickiness itself, as a countercyclical markup could also be implied by models with flexible prices when the desired markup changes in response to a shock. (3) A model which assigns a central role to markups for fiscal policy transmission has been presented by Ravn, Schmitt-Grohe, and Uribe (2007). Assuming that demand has a price-inelastic component that is a function of deep habits, a government spending shock that leads to a positive output response increases the share of the price-elastic component of demand, causing a rise in the overall demand elasticity and a corresponding decline in the optimal markup. (4) Thus, for a sufficient decline in the markup, the resulting rise in wages induces households to substitute away from leisure and into consumption, thereby more than offsetting the negative wealth effect of government spending, predicted by the neoclassical model. …