What are the Effects of Fiscal Policy Shocks?

Abstract

We propose and apply a new approach for analyzing the effects of fiscal policy using vector autoregressions. Specifically, we use sign restrictions to identify a government revenue shock as well as a government spending shock, while controlling for a generic business cycle shock and a monetary policy shock. We explicitly allow for the possibility of announcement effects, i.e., that a current fiscal policy shock changes fiscal policy variables in the future, but not at present. We construct the impulse responses to three linear combinations of these fiscal shocks, corresponding to the three scenarios of deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion. We apply the method to US quarterly data from 1955-2000. We find that deficit-financed tax cuts work best among these three scenarios to improve GDP, with a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue five years after the shock.

Why does private consumption rise after a government spending shock?

“…Overall, our empirical findings are similar to those reported by Fatás and Mihov (2001), Blanchard and Perotti (2002), Perotti (2004), Galí, López-Salido, and Vallés (2005), and to a lesser extent, Mountford and Uhlig (2005). 8 Interestingly, these authors find a positive effect of public spending on consumption albeit using different identification strategies: While, as stated above, Fatás and Mihov (2001) and Galí, López-Salido, and Vallés (2005) rely on a recursive identification 6 As pointed out by a referee, the double-sided nature of the standard H-P filter conflicts with the recursive identification approach adopted in this paper.…”

Using Stock Returns to Identify Government Spending Shocks

“…We emphasise that our new measure, based on the stock returns of large military contractors, avoids the main shortcomings of two popular alternatives. In this sense it is complementary to the sign restriction strategy used by Mountford and Uhlig (2002) which is robust to many of the shortcomings of the other strategies as well.…”

“…Essentially, this involves identifying a government spending shock with the Choleski innovation to government spending in a vectorautoregression (VAR) with government spending ordered first. Many other papers have used this approach, including Berndt et al (2009), Fatas and Mihov (2001), Gali et al (2007), Mountford and Uhlig (2002) and Perotti (2002Perotti ( , 2007. This approach typically finds that output, hours, consumption and real wages all rise after a positive government spending shock.…”

Measuring the time‐varying effects of fiscal policy on private saving in the process of financial integration

“…() impose short‐run restrictions on the VAR system. Mountford and Uhlig () devise a sign restriction scheme to identify fiscal shocks. Auerbach and Gorodnichenko (2012a, 2012b) and Furceri and Li () construct the forecast errors of government expenditure.…”