Fiscal Shocks Research Articles

Fiscal Policy, International Spillovers, and Endogenous Productivity

AbstractThe paper presents empirical evidence on the international effects of U.S. fiscal policy from structural vector autoregressions identified through external instruments in a panel setting for the G7 countries. An exogenous increase in U.S. government spending is estimated to produce sizable positive responses of output and consumption in the rest of the G7 countries, both about half as large as their domestic U.S. counterparts, while strongly depreciating the U.S. terms of trade and lowering the U.S. trade balance and short‐run real interest rates. Moreover, fiscal shocks are estimated to have a strongly positive impact on hourly labor productivity in the private sector. We solve a two‐country New Keynesian model in closed form and show that a low cost elasticity of varying technology utilization can simultaneously explain the positive productivity, consumption, and international spillover effects as well as the real depreciation resulting from expansionary U.S. government spending shocks.

UK fiscal policy and external balance under Bretton Woods: Twin deficits or distant relatives?

AbstractThe United Kingdom (UK) is typically regarded as the sine qua non case of an economy experiencing chronic external imbalances under the post‐war Bretton Woods system, apparently unable to reconcile the divergent objectives of robust economic growth and current account equilibrium. This paper investigates the famed ‘twin deficits hypothesis’, which ascribed responsibility for the UK's current account woes to an excessively lax fiscal policy. Calling on two distinct approaches to identifying fiscal shocks, we find evidence decisively against the traditional twin deficits view, and uncover serious shortcomings in the way that both policymakers and academics conceptualized the transmission of fiscal policy to the current account. Our results demonstrate that factors other than fiscal policy are of considerably greater importance for understanding the UK's historical experience, and we elaborate on the need for a reappraisal of some classic policy debates concerning external adjustment under the Bretton Woods system.

The impact of fiscal shocks on economic growth and income inequality in Ghana: is there a trade-off?

PurposeThe study examines the impact of fiscal policy shocks on economic growth and income inequality in Ghana. This has become necessary because of the interdependence between growth and income inequality and the role fiscal policy plays in this relationship in the development process of a country. Thus, a study that investigates how government expenditure shock and tax revenue shock influence the relationship between economic growth and income inequality could assist policymakers to adopt the best policy mix to ensure income equity and sustained economic growth in Ghana.Design/methodology/approachIt employs sacrifice ratio from structural VAR model using quarterly time series data from 1996 to 2019 on Ghana.FindingsOur results show that government expenditure shock impacts economic growth, exchange rate and education positively and significantly in the long run. Also, tax revenue shock has a positive impact on income inequality, economic growth and education. The findings further show that there exists a trade-off between economic growth and income inequality in the long run.Originality/valueThe relationships between fiscal policy shocks, economic growth and income inequality have been extensively discussed among scholars. Understanding how these three macroeconomic variables are determined and their interrelationships are crucial for policymakers. This is because fiscal policy aids in both economic growth and income inequality. In the empirical literature, the emphasis has been on independently estimating the growth effects of fiscal policy or the distribution effects of fiscal policy, leaving out the existence of possible trade-off between economic growth and income inequality following a fiscal shock. To the best of our knowledge, no empirical study has been done on Ghana to empirically examine the trade-off between economic growth and income inequality as we do in this paper.

Supply Disruptions and Fiscal Stimulus: Transmission through Global Value Chains

We study the impact of demand and supply factors on bottlenecks and inflation during the COVID-19 pandemic. Initial policy interventions, from lockdowns to fiscal stimuli, triggered shifts in consumer spending and supply chain disruptions. The reopening of economies normalized consumption patterns, but attributing bottlenecks to specific factors remains challenging due to diverse policy responses. This paper empirically integrates fiscal spending, mobility measures, and supply constraints to analyze interconnected factors influencing bottlenecks and inflation internationally. We find an important role played by fiscal shocks and the international propagation of demand and supply forces in shaping bottlenecks and inflation dynamics.

Made in Europe: Monetary–Fiscal policy mix with financial frictions

We study the role of fiscal and monetary policies in a financially constrained economy. An active monetary–passive fiscal regime amplifies technology shocks, mitigates preference shocks, and neutralizes the expansionary effects of fiscal shocks through “debt deflation” and “real interest rate” channels, compared to an active fiscal–passive monetary policy regime. Several features of the data suggest that in the aftermath of the 2007 Financial crisis, the monetary policy in the United States was more dovish than in the Euro Area while fiscal policy seemed less concerned about the dynamics of sovereign debt, implying that the distinct post-crisis dynamics of the United States and the Euro area can be rationalized through different fiscal and monetary policy mixes.

The “Benefits” of being small: Loose fiscal policy in the European Monetary Union

Independent central banks typically counteract positive fiscal shocks that would otherwise increase the inflation rate above the target. In a theoretical model, we show that, in a monetary union, this mechanism implies weaker responses to national fiscal shocks because the overarching central bank must account for the fiscal policies of all members. The model highlights that the response is especially weak for small members, given their marginal impact on the union’s aggregate inflation rate. Empirically, we exploit the exogenous variation in elections to show that the European Central Bank reacts more vigorously to fiscal shocks from larger countries. We then provide evidence that small countries take advantage of this; they engage more in fiscal expansions during election years than large countries. In an extension, we discuss, both theoretically and empirically, why the difference between small and large countries disappears in times of crisis.

Sovereign risk and bank lending: Evidence from 1999 Turkish Earthquake

We use an exogenous fiscal shock to identify the transmission of government risk to bank lending due to banks holding government bonds. We illustrate with a theoretical model that for banks with higher exposure to government bonds, a higher sovereign default risk implies lower bank net worth and less lending. Our empirical estimates confirm the model’s predictions. The exogenous change in sovereign default risk of Turkish government debt as a result of the 1999 Earthquake impacted banks whose balance sheets were exposed more to government bonds. The resulting lower bank net worth translates into a lower credit supply. We rule out alternative explanations. Our estimates suggest this channel can explain half of the decline in bank lending following the earthquake. This underlines the importance of the bank balance-sheet channel in transmitting a higher sovereign default risk to reduced real economic activity.

The return of expansionary austerity: Firms' investment response to fiscal adjustments in emerging markets

In emerging markets, unexpected public expenditure reductions increase firm-level investment, which quickly surpasses pre-shock levels after a temporary contraction, owing to a decline in financing costs. Consistent with the role played by financing cost dynamics and financial frictions, we show that countries with lower sovereign credit ratings (those that are not investment grade) experience a sharper boost in investment. In addition, we find that investment's recovery is facilitated by trade openness, public spending predictability, and exchange rate flexibility. In fact, exchange rate flexibility facilitates the real depreciation that result from the fiscal adjustment, which decreases (relative) domestic demand for non-tradable (akin to Diaz-Alejandro, 1966) and increases external demand for tradables, boosting investment. We show that adjustment composition matters: reductions in public consumption (vis-à-vis public investment) yield larger private investment contractions on impact but result in quicker and more sustainable recoveries. Exploiting firm-level heterogeneity we show that investment's expansion is stronger in the tradable-sector, in larger, and in less indebted firms. We provide evidence that the medium-term benefits of fiscal shocks to firm-level activity outweigh their short-run costs.

AN ASSESSMENT OF THE FELDSTEIN–HORIOKA PUZZLE FOR INDIA: A MARKOV REGIME SWITCHING APPROACH

The study aims to examine the Feldstein–Horioka puzzle in the Indian context during 2002Q2 to 2019Q4 to unearth nonlinear patterns in the data. Findings from an augmented Markov regime-switching model reveal two distinct, yet random regimes for correlations between savings and investment-GDP ratios, with higher correlation between the variables persisting for a longer duration. In the low correlation regime, trade-related factors, policy uncertainty and global shocks have a significant impact on the correlation. Fiscal shocks and trade costs explain high correlations in regime 2, while global shocks act to decrease the correlation in this regime. The high correlation regime dominates the study period and indicates that the Feldstein–Horioka puzzle of limited capital mobility persists in India. Economic agents appear to respond rapidly to changing domestic and global policy conditions, besides being affected by incomplete integration of goods markets, explaining the pattern of correlations.

Public expenditure multipliers and informality

This paper investigates the role of informality in affecting the magnitude of the public expenditure multiplier in a panel of 142 countries, using the local projections method. We find a strong negative relationship between the degree of informality and the size of the multiplier. This result holds irrespective of the level of economic development and institutional quality and is robust to additional country characteristics such as trade and financial openness and exchange rate regime. In a two-sector New-Keynesian model, we rationalize this result by showing that fiscal shocks raise the relative price of official goods, thereby shifting demand towards the informal sector. This reallocation effect increases with the level of informality, because a larger informal sector is associated with a stronger appreciation of relative prices in response to fiscal shocks, and thus reduces the multiplier.

From parameters to policies: sensitivity analysis and fiscal and monetary reactions

PurposeThis paper seeks to explore the sensitivity of these parameters and their impact on fiscal policy outcomes. We use the existing literature to establish possible ranges for each parameter, and we examine how changes within these ranges can alter the outcomes of fiscal policy. In this way, we aim to highlight the importance of these parameters in the formulation and evaluation of fiscal policy.Design/methodology/approachThe role of fiscal policy, its effects and multipliers continues to be a subject of intense debate in macroeconomics. Despite adopting a New Keynesian approach within a macroeconomic model, the reactions of macroeconomic variables to fiscal shocks can vary across different contexts and theoretical frameworks. This paper aims to investigate these diverse reactions by conducting a sensitivity analysis of parameters. Specifically, the study examines how key variables respond to fiscal shocks under different parameter settings. By analyzing the behavioral dynamics of these variables, this research contributes to the ongoing discussion on fiscal policy. The findings offer valuable insights to enrich the understanding of the complex relationship between fiscal shocks and macroeconomic outcomes, thus facilitating informed policy debates.FindingsThis paper aims to investigate key elements of New Keynesian Dynamic Stochastic General Equilibrium (DSGE) models. The focus is on the calibration of parameters and their impact on macroeconomic variables, such as output and inflation. The study also examines how different parameter settings affect the response of monetary policy to fiscal measures. In conclusion, this study has relied on theoretical exploration and a comprehensive review of existing literature. The parameters and their relationships have been analyzed within a robust theoretical framework, offering valuable insights for further research on how these factors influence model forecasts and inform policy recommendations derived from New Keynesian DSGE models. Moving forward, it is recommended that future work includes empirical analyses to test the reliability and effectiveness of parameter calibrations in real-world conditions. This will contribute to enhancing the accuracy and relevance of DSGE models for economic policy decision-making.Originality/valueThis study is motivated by the aim to provide a deeper understanding of the roles macroeconomic model parameters play concerning responses to expansionary fiscal policies and the subsequent reactions of monetary authorities. Comprehensive reviews that encompass this breadth of relationships within a single text are rare in the literature, making this work a valuable contribution to stimulating discussions on macroeconomic policies.

Fiscal Policy in a DSGE Model of a Resource-Rich Emerging Economy: The Nigerian Experience

This paper examines the role of fiscal policy in driving macroeconomic dynamics in a resource-rich emerging economy like Nigeria. Specifically, the paper investigates the macroeconomic implications of fiscal policy using a small open economy dynamic stochastic general equilibrium model that features oil in the fiscal rule. The model is estimated via Bayesian methods using data covering the period 2010Q1- 2021Q1. The results show that the feedback coefficient of output in the fiscal rules is mainly negative, indicating a counter-cyclical fiscal stance. Also, increased oil revenue leads to a rise in government consumption, investment and transfer payments. Further evidence indicates that government spending and transfer payments rose in response to increased debt. We also show that fiscal shocks are highly persistent and that government spending on consumption and investment, tax instruments and transfer are expansionary.

Regional fiscal spillovers: The role of trade linkages

This paper examines how fiscal shocks in a given country affect foreign regions through regional trade linkages. Applying the local projection method to a panel of 222 NUTS-2 regions in 20 European countries during the period 1993–2020, we find that countries-to-regions fiscal spillovers are positive, statistically significant, persistent, and non-negligible in size. In addition, fiscal spillovers tend to be larger when the recipient region experiences a recession, when monetary policy of the recipient country is at the zero-lower-bound, and when the recipient region and the source country are both part of the European Monetary Union.

Capital and labor taxes with costly state contingency

We analyze optimal capital and labor taxes in a model where (i) the government makes noncontingent announcements about future policies and (ii) state-contingent deviations from these announcements are costly. With Full Commitment, optimal announcements coincide with expected future taxes. Costly state contingency dampens the response of both current and future capital taxes to government spending shocks and labor taxes play a major role in accommodating fiscal shocks. These features allow our quantitative model to account for the volatility of taxes in US data. In the absence of Full Commitment, optimal announcements are instead strategically biased, because governments have an incentive to partially constrain their successors. The cost of deviating from past announcements generates an endogenous degree of fiscal commitment, determining the average level of capital taxes.

Macroeconomic effects of fiscal policy shocks: panel VAR evidence from MENA countries

ABSTRACT This study examines discretionary fiscal policy effects on output by employing a Panel VAR model in MENA countries during 1990–2018. the results demonstrate fiscal multipliers are larger when public debt is low, at a high institutional quality, and during recession periods. Contrary to empirical studies, we found the response of output to fiscal shocks is larger at a low level of financial development. Our findings have significant policy implications focusing on fiscal policy mix in downturns of an economy, lower levels of public debt, lower levels of financial development, and a higher level of institutional quality.

Governments' fiscal stress and firm decentralization

We examine whether and how fiscal stress on local governments affects the decentralization of state-owned enterprises (SOEs). By employing a fiscal shock entailing an average revenue decline of 13.5% across local governments in China, we undertake difference-in-differences design to discern the effect of fiscal pressures on the decentralization of SOEs. Our findings reveal that fiscal stresses of local governments curb SOEs' decentralization. In the context of evaluating the delicate trade-off between control costs and claim rights, against the intrinsic value of localized information, local governments, particularly during challenging fiscal periods, tend to exhibit a tendency towards centralizing SOEs. Furthermore, local governments are more likely to centralize SOEs with greater tax contribution, higher productivity, and better performance in hard fiscal times, while the effects of fiscal stress on the inhibition of SOEs' decentralization are weakened by greater geographical distance to oversight government and weak government intervention.

Fiscal risk management in Ukraine under new challenges

This article examines fiscal risks and their management in Ukraine and abroad, drawing on international best practices. The main aim is to analyze global risks in the short and long term and evaluate how public finances have been managed in Ukraine and other countries during economic crises, while suggesting areas for improvement. The study utilized various scientific methods, including the structural-functional method to uncover risk management mechanisms within public finance systems and the comparative method to contrast key indicators of Ukraine's public finance system with those of other nations. Key findings include the identification of primary tools used nationally and internationally to mitigate the impact of fiscal shocks during crises. Budgetary practices from different countries were also examined, emphasizing fiscal rules, social expenditure allocation, and incentives for innovation and investment. The research highlights how global challenges and economic crises have led countries to adopt different approaches based on their economic development and risk management integration into fiscal processes. Recommendations are provided to enhance fiscal risk management measures in Ukraine, particularly in the ongoing wartime context. In conclusion, this article underscores the importance of effective fiscal risk management and offers specific suggestions to strengthen fiscal risk management practices in Ukraine, considering current circumstances and unforeseen challenges.

Fiscal multipliers, public debt anchor and government credibility in a behavioural macroeconomic model

We develop a behavioural macroeconomic model to investigate the question of fiscal policy credibility and how agents’ expectations about the output gap, public debt, expenditure and taxation affect the fiscal multiplier and debt stability. To do this, we model heterogeneous expectation-formation processes in a market populated by fundamentalists and chartists, agents being able to switch from one rule to another depending on the effective outcome in each period. This model produces waves of optimism and pessimism along the business cycle. We show in this article that when agents are optimistic about the future output gap and public debt, the fiscal multiplier tends to be larger whatever the nature of the fiscal shock. It also appears that fiscal expansion has less of a negative effect on public debt. Furthermore, agents’ expectations about public debt and the fiscal credibility of the government affect indicators of government performance (the fiscal multiplier and public debt stability).

A Fiscal Theory of Persistent Inflation

Abstract We develop a new class of general-equilibrium models with partially unfunded debt to propose a fiscal theory of persistent inflation. In response to business cycle shocks, the monetary authority controls inflation and the fiscal authority stabilizes debt. However, the central bank accommodates unfunded fiscal shocks, causing persistent movements in inflation, output, and real interest rates. In an estimated quantitative model, fiscal inflation accounts for the bulk of inflation dynamics. In the aftermath of the pandemic, unfunded fiscal shocks sustain the recovery but also cause a persistent increase in inflation. The model is able to predict the inflationary effects of the American Rescue Plan Act fiscal stimulus out of sample and with real-time data.

Fiscal Stimulus and the Systematic Response of Monetary Policy

Economic theory suggests that the effects of fiscal stimulus can vary substantially with the systematic response of monetary policy. Empirical estimates of the causal effects of fiscal shocks implicitly embed a particular monetary reaction: they provide treatment effects that average across in-sample monetary policy. Building on McKay and Wolf (2022), I discuss how evidence on monetary policy shocks can be used to predict the effects of fiscal stimulus under arbitrary monetary policy reaction. I review the underlying theory, propose a simple empirical strategy, and present an application.