Fiscal Shocks Research Articles

Financial and fiscal shocks in the great recession and recovery of the Spanish economy

In this paper we develop a new DSGE model for a small open economy in a currency union, estimated with Bayesian methods, which incorporates a banking and a housing supply sector, consumers and entrepreneurs who accumulate debt, a rich structure of fiscal variables and monopolistic competition in products and labor markets. As an example of its capabilities, the model has been estimated for the Spanish economy, which is an interesting example of a booming economy before the Great Recession, and a country that particularly suffered from the negative consequences of the sovereign debt crisis and exhibited a robust recovery until 2019. Our results show the usefulness of DSGE models, conveniently designed and extended to account for the interaction of real and financial variables and other prominent characteristics of modern economies, as part of our toolkit to analyze the empirical evidence.

Public Liquidity Demand and Central Bank Independence

This paper studies how a crisis that induces a large negative fiscal shock and a strong demand for safe stores of value affects the independence of a central bank vis-a-vis a fiscal authority that seeks to inflate away public liabilities. We find that the central bank can maintain price stability only if there is a large demand for its liabilities, so that it can control the net increase in government debt held by the private sector. We show that fiscal requirements are necessary even with low interest rates and massive reserve issuance is not necessarily a sign of fiscal dominance.

Macroeconomic responses to fiscal shocks in Portugal

PurposeThis study analyses the impact of fiscal shocks on GDP, inflation and interest rates in Portugal over 1995–2017.Design/methodology/approachMultipliers are estimated using a structural VAR (SVAR) a' la Blanchard and Perotti (2002) using OECD elasticities. Changes in direct and indirect taxes are considered for fiscal shocks on the revenue side and changes in public consumption, investment and transfers for fiscal shocks on the expenditure side.FindingsThe analysis finds small tax multipliers and larger government consumption multipliers for growth, while short-term responses to shocks in transfer and investment spending are found to be negligible. Fiscal shocks have an ambiguous impact on inflation, and fiscal shocks of an expansionary nature are found to trigger declines in interest rates. The results are robust to different orderings of variables, to the selection of an alternative time period which excludes the financial crisis and to an alternative estimation technique.Research limitations/implicationsA major limitation of the study relates to the relatively short time period which does not allow capturing the impact of possible structural breaks.Practical implicationsThis analysis is relevant for countries, like Portugal, that display high debt levels and volatile market sentiment and lack an independent monetary policy.Originality/valueOverall, the analysis of output multipliers compares well with some other studies conducted on the Portuguese economy and confirms the importance of the disposable income channel in the transmission of fiscal shocks to the rest of the economy. The study is one of the first to focus also on the implications of fiscal shocks on inflation and long-term interest rates. It is the first to apply the local projection method to estimate multipliers in Portugal.

The Time-series Linkages between US Fiscal Policy and Asset Prices

This article studies the interplay of fiscal policy and asset price returns of the United States in a time-varying parameter vector autoregressive (VAR) model. Using annual data from 1890 to 2013, we study the effects of dynamic shocks to both fiscal policy on asset returns and asset returns on fiscal policy. Distinguishing between low-volatility (bull market) and high-volatility (bear market) regimes together with a time-varying parameter VAR model enables us to isolate the different sizes and signs of responses to shocks during different time periods. The results indicate that increases in the primary surplus-to-gross-domestic-product ratio decrease house returns over the entire sample and at each impulse horizon. Unlike the house return responses, stock returns only decrease in the first year after the fiscal shock but then increase for the following eight years. Furthermore, the findings show that asset return movements affect fiscal policy, whereby fiscal policy responds more to equity returns than to house returns. The response of fiscal policy to asset returns proves relatively stable and constant over time while controlling for various asset return regimes. Asset returns respond uniformly to fiscal policy shocks since the 1900s.

Spillover effects of fiscal policy in a monetary union: Why do fiscal instruments matter?

AbstractUsing a two‐country DSGE model, we analyse the spillover effects of fiscal policy in a monetary union. Based on a non‐Walrasian labour market with a labour force participation decision and involuntary unemployment and a detailed fiscal sector, we focus on the relative cross‐border effects of different kinds of fiscal shocks (government expenditure and tax shocks). Among the major lessons from this analysis, five general and striking results are worth highlighting : (1) spillover effects differ widely according to the fiscal instrument, (2) all fiscal instruments produce positive spillover effects on foreign GDP except a rise in government consumption, (3) the response of unemployment is not always negatively correlated with the response of output (4) the different fiscal shocks trigger different effects on foreign inflation and the term of trade, which implies heterogeneous interest‐rate and trade channels, and (5) a more accommodative monetary policy and a scenario of ‘fiscal dominance’ alter greatly the effects of fiscal policy shocks.

The Impact of Fiscal Policy on Aggregate Economic Activity: A Regime Dependent Impulse Response Analysis

Asymmetries in fiscal policies cannot be captured by linear time series models. In order to examine the asymmetry responses of output in different phases of the business cycle, Markov Regime Switching (MRS) model is an alternative technique that is used to achieve the objective. The main objective of this study is to empirically explore the effects of fiscal shocks (spending and taxes) on Pakistan’s overall economic activity GDP while utilizing Markov Switching MS-VAR model. The model is characterized to allow for the variation in mean, coefficients and in error variances. The study results show that the effect of shocks and the size of multiplier varies across regimes confirming the asymmetric behavior of fiscal policy transmission mechanism. Moreover, the impact of positive spending shock has a stronger effect on output in the recession as compared to boom. One surprising result of the study is that the tax shock increases the output both in recession and boom. Lastly, spending and revenue behave a-cyclically.
 JEL Classification Codes: C11; C32; E62

Analysis of tax-spend nexus for Russian regional budgets

We study the tax-spend nexus for Russian regional budgets. Causal relationship running from taxing to spending is found, thus supporting the concept “tax and spend” suggested by M. Friedman. Next, elasticity of expenditure by revenue is estimated for a panel of 80 regional budgets basing on data for 2000—2017. Estimates are in the range of 0.72 to 0.78 (depending on the econometric technique), which exceeds elasticity for the federal budget more than twice. This evidences that fiscal policy at the sub-federal (as distinct from the federal) level has clear pro-cyclical nature. Besides, the largest sensitivity of expenditure to revenue shocks is found for the item “national economy”, implying marked adverse implications for economic growth. We suggest to mitigate this effect by modifying fiscal rules for sub-federal budgets. They are currently aimed primarily at enhancing fiscal discipline, with less emphasis on countercyclical policy, insulating economy from fiscal shocks.

How Big are Fiscal Multipliers in Latin America?

This paper uses the strategy and data of Blanchard and Perotti (BP) to identify fiscal shocks and estimate fiscal multipliers for the United States. With these results, it computes the cumulative multiplier of Ramey and Zubairy (2018), now common in the literature. It finds that, contrary to the peak and through multipliers reported by BP, the cumulative tax multiplier is much larger than the cumulative spending one. Hence, the conclusions depend on the definition of multiplier. This methodology is also used to estimate the effects of fiscal shocks on economic activity in eight Latin American countries. The results suggest that the fiscal multipliers vary significantly across countries, and in some cases multipliers are larger than previously estimated.

Endogenous overhead costs, firm size, and fiscal shocks

AbstractRecent empirical observations indicate that firm size responds to cyclical fluctuations in economic activities. By analyzing the effects of endogenous overhead costs in the economy, this paper finds that in response to a fiscal expansion, firm size will increase if the relationship between overhead costs and the number of firms is positive, while firm size will decrease if the relationship is negative.

How Big are Fiscal Multipliers in Latin America?

This paper uses the strategy and data of Blanchard and Perotti (BP) to identify fiscal shocks and estimate fiscal multipliers for the United States. With these results, it computes the cumulative multiplier of Ramey and Zubairy (2018), now common in the literature. It finds that, contrary to the peak and through multipliers reported by BP, the cumulative tax multiplier is much larger than the cumulative spending one. Hence, the conclusions depend on the definition of multiplier. This methodology is also used to estimate the effects of fiscal shocks on economic activity in eight Latin American countries. The results suggest that the fiscal multipliers vary significantly across countries, and in some cases multipliers are larger than previously estimated.

An Empirical Stock-Flow Consistent Macroeconomic Model for Denmark

This paper emphasizes the need for understanding the interdependencies between the real and financial sides of the economy in macroeconomic models. While the real side of the economy is generally well explained in macroeconomic models, the financial side and its interaction with the real economy remains poorly understood. This paper makes an attempt to model the interdependencies between the real and financial sides of the economy in Denmark while adopting a stock-flow consistent approach. The model is estimated using Danish data for the period 1995–2016. The model is simulated to create a baseline scenario for the period 2017– 30, against which the effects of two standard shocks (fiscal shocks and interest rate shocks) are analyzed. Overall, our model is able to replicate the stylized facts, as will be discussed. While the model structure is fairly simple due to different constraints, the use of the stockflow approach makes it possible to explain several transmission mechanisms through which real economic behavior can affect the balance sheets, and at the same time capture the feedback effects from the balance sheets to the real economy. Finally, we discuss certain limitations of our model.

The Nonlinear Effects of Fiscal Policy

We argue that the fiscal multiplier of government purchases is increasing in the shock, in contrast to what is assumed in most of the literature: the fiscal multiplier is largest for large positive government spending shocks and smallest for large contractions in government spending. We empirically document this fact by analyzing two independent datasets and using two different empirical approaches. We find that a neoclassical, life-cycle, incomplete markets model calibrated to match key features of the US economy, including the distribution of wealth, can well explain this empirical finding. The mechanism works through the relationship between fiscal shocks, the distribution of wealth and the aggregate labor supply elasticity: liquidity constrained agents have less elastic labor supply responses to changes in future income. An increase (decrease) in government spending today acts as a negative (positive) shock to future income, as future wages will be lower (higher). A large increase (decrease) in government spending today will induce saving (borrowing) and move a larger fraction of the agents in the economy away from (towards) the borrowing limit. Analysis of micro-data confirms the mechanism.

Debt management when monetary and fiscal policies clash: some empirical evidence

ABSTRACT We explore the effects of fiscal and monetary policy shocks on key debt management variables and provide empirical evidence supporting the notion of a strict separation of economic policy from the debt management agenda. We find that a tighter monetary policy coupled with fiscal expansion increases the risk that government debt will have to be rolled over at unusually high cost. This is especially the case in a downturn, where low or even negative interest rates often provide incentives for debt managers to invest predominantly in short-term bonds. Our findings echo the post-crisis environment of low or even negative interest rates, where many debt managers altered their portfolios’ structure in favor of short-term bonds. In this respect, we argue that debt managers should use a longer optimization horizon and base their strategy on the medium- and long-term economic outlook.

Questioning the Puzzle: Fiscal Policy, Exchange Rate and Inflation

The paper re-investigates the effects of government spending shocks on the real exchange rate and inflation, using US data. In opposition to some previous puzzling results, we find that an increase in government spending appreciates the real exchange rate and generates inflationary pressures. Positive spending shocks also induce a trade balance deficit and an increase in the nominal interest rate. The discrepancy with the existing literature lies in the identification of fiscal shocks: embedding a narrative instrument within a proxy-SVAR model is what makes the difference. Findings are robust and coherent with a standard open economy business cycle model. Our analysis suggests that proxy-SVAR models are more immune to structural changes in US fiscal policy.

Are Fiscal Multipliers Estimated with Proxy-SVARs Robust?

How large are government spending and tax multipliers? The fiscal proxy-SVAR literature provides heterogenous estimates, depending on which proxies - fiscal or non-fiscal - are used to identify fiscal shocks. We reconcile the existing estimates via a flexible vector autoregressive model that allows to achieve identification in presence of a number of structural shocks larger than that of the available instruments. Our two main findings are the following. First, the estimate of the tax multiplier is sensitive to the assumption of orthogonality between total factor productivity (non-fiscal proxy) and tax shocks. If this correlation is assumed to be zero, the tax multiplier is found to be around one. If such correlation is non-zero, as supported by our empirical evidence, we find a tax multiplier three times as large. Second, we find the spending multiplier to be robustly larger than one across different models that feature different sets of instruments. Our results are robust to the joint employment of different fiscal and non-fiscal instruments.

Incumbency and Expectations of Fiscal Rule Compliance: Evidence from Surveys of German Policy Makers

We analyze politicians’ expectations about future compliance with a fiscal rule, and in particular the dependence of the expectations on their role in parliament (opposition vs. incumbent government coalition). We study this in the context of the German debt brake, which became a constitutional provision in 2009 but is binding for the sub-national states from 2020 onwards only. Via a unique survey, we analyze compliance expectations of parliamentarians of all 16 German state parliaments. A strong incumbency effect is identi-fied from parlamentarians who move in and out of government, showing that politicians from the governing coalition are more optimistic than those from the opposition. A nega-tive fiscal shock has little effects on the former, but a strongly negative one on the latter. We offer a theoretical model that is consistent with an increasing incumbency effect over time, as the result of wishful thinking by politicians concerning their reelection chances and a dynamic reputation effect for policymakers when compliance with the fiscal rule is achieved.

Monetary and Fiscal Policies in Times of Large Debt: Unity is Strength

We build and estimate a novel TANK model with partially unfunded debt to study whether the record high debt-to-GDP ratio threatens US inflation stability. In response to business cycle shocks, the monetary authority controls inflation, and the fiscal authority stabilizes debt. The central bank accommodates unfunded fiscal shocks, causing persistent movements in inflation and real interest rates, leading to a fiscal theory of trend inflation. Fiscal trend inflation accounts for the bulk of inflation dynamics. The current situation is in line with historical experience. Unfunded shocks sustain the recovery and cause a temporary inflation increase that counteracts deflationary non-policy shocks.

A narrative approach to a fiscal DSGE model

Structural DSGE models are used for analyzing both policy and the sources of business cycles. Conclusions based on full structural models are, however, potentially affected by misspecification. A competing method is to use partially identified SVARs based on narrative shocks. This paper asks whether both approaches agree. Specifically, I use narrative data in a DSGE‐SVAR that partially identify policy shocks in the VAR and assess the fit of the DSGE model relative to this narrative benchmark. In developing this narrative DSGE‐SVAR, I develop a tractable Bayesian approach to proxy VARs and show that such an approach is valid for models with a certain class of Taylor rules. Estimating a DSGE‐SVAR based on a standard DSGE model with fiscal rules and narrative data, I find that the DSGE model identification is at odds with the narrative information as measured by the marginal likelihood. I trace this discrepancy to differences in impulse responses, identified historical shocks and policy rules. The results indicate monetary accommodation of fiscal shocks.

A tool for fiscal policy planning in a medium-term fiscal framework: The FMM-MTFF model

This paper describes the FMM-MTFF model, a dynamic stochastic general equilibrium model developed to support the implementation of a Medium-Term Fiscal Framework (MTFF) in emerging market and developing economies. The model exhibits the following features. First, fiscal policy is defined in terms of multi-year fiscal plans, instead of restricting attention to univariate, single-period fiscal shocks. Second, the model temporarily deactivates the fiscal rule to avoid forcing fiscal policy to be mechanically countercyclical and sustainable. Third, the model is calibrated to match a three-sector, stylized version of a country’s input-output table, and finally, the model uses a chain-weighted procedure to measure GDP, a method consistent with what national account compilers do. The model is calibrated to Colombian and Peruvian data to illustrate the use of the model as a tool to quantify the scale of the fiscal challenges, to provide consistent medium-term macro fiscal projections and to assess the quantitative implications of past reforms and alternative fiscal policy plans on the economies, i.e., the typical questions of interest to an MTFF.

The impact of fiscal shocks on real GDP and income inequality: What do Australian data say?

This paper examines the impact of three fiscal policy shocks on per capita real GDP and income inequality in Australia during the period 1965–2014. A small structural vector autoregressive (SVAR) model is constructed for an open economy for contemporaneous identification and estimation purposes. Based on the evidence of one cointegrating vector among the variables, a structural vector error correction (SVEC) model is specified for the long run. Direct taxation, indirect taxation receipts and government spending are identified as permanent fiscal policy shocks. The convergent use of two different models (SVAR & SVEC) strengthens the credibility of the results. The results have three key policy implications. First, a reduction in direct taxation receipts increases per capita real GDP without increasing income inequality. Second, a reduction in government expenditure significantly increases income inequality. Third, the adverse effect of indirect taxation receipts on income inequality is greater than the redistributive effect of government expenditure, which questions the widely held fiscal policy strategy of using indirect taxation to finance redistributive expenditure.