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. Unlike most of the previous literature this approach does not require that the contemporaneous reaction of some variables to fiscal policy shocks be set to zero or need additional information, such as the timing of wars, in order to identify fiscal policy shocks. The paper's method is a purely vector autoregressive approach which can be universally applied. The approach also has the advantages that it is able to model the effects of announcements of future changes in fiscal policy and that it is able to distinguish between the changes in fiscal variables caused by fiscal policy shocks and those caused by business cycle and monetary policy shocks. We apply the method to US quarterly data from 1955-2000 and obtain interesting results. Our key finding is that the best fiscal policy to stimulate the economy is a deficit-financed tax cut and that the long term costs of fiscal expansion through government spending are probably greater than the short term gains.JEL Codes: C32, E60, E62, H20,H50,H60.

The Macroeconomic Effects of Exogenous Fiscal Policy Shocks in Germany: A Disaggregated SVAR Analysis

“…They are confirmed by Edelberg, Eichenbaum, and Fisher (1999) who adopt an extended version of the Ramey-Shapiro approach in terms of a vector autoregressive (VAR) specification. Mountford and Uhlig (2005) introduce shock identification by sign restrictions on the impulse responses in a VAR with fiscal data. They find a weak stimulation of private consumption and output along with a fall in residential and non-residential investment after a spending shock for US data.…”

“…However, the effects of fiscal policy on the macroeconomy are still object of empirical research, and stylized facts have not been established yet -in contrast to analyses on monetary policy effects. Most studies investigate fiscal policy in the US (Blanchard and Perotti (2002), Fatás and Mihov (2001), Mountford and Uhlig (2005), Ramey and Shapiro (1997) …”

Financial Fragility and the Fiscal Multiplier

“…In this section we extend the two-period model to an infinite-horizon DSGE model to quantitatively assess to what extent the drop in investment, which is the result of reduced/more expensive lending to the real economy, can offset the positive direct effects on output from higher government purchases, and see which effect dominates by looking at a cumulative discounted multiplier (Mountford and Uhlig, 2009). …”

“…The debate on the size of the fiscal multiplier has been at the forefront of academic research ever since the financial crisis of 2007-2009(Christiano et al, 2011Eggertsson, 2011;Woodford, 2011). In this paper, we focus on the role of undercapitalized commercial banks that have large holdings of domestic government bonds with substantial default risk on their balance sheet.…”

“…Our model allows us to quantitatively investigate the extent to which the stimulative effects from expansionary fiscal policy are offset by disruptions to the commercial banking system. The main result is that the cumulative impact on output, measured by the cumulative discounted multiplier (Mountford and Uhlig, 2009), is much reduced and possibly turns negative once government bonds are long term and subject to sovereign default risk, the more so the longer the maturity and the larger the risk of sovereign default. Additional debt issue, necessary to finance the stimulus, increases sovereign default risk, which in turn leads to capital losses on existing government bond holdings of the commercial banking system.…”