Under threat: Rules-based fiscal policy and how to preserve it

Rules-based fiscal policy is under threat. Over the last two decades, it proved frustratingly complicated to strike the right balance between three essential properties of sound fiscal policy rules: simplicity, flexibility, and enforceability. Simplicity has been sacrificed to ensure that more contingent (i.e. flexible) rules remained enforceable. The resulting arrangements have failed to adequately guide fiscal policy, undermining formal compliance, and ultimately, popular and political support for rules. To mitigate the risk that countries abandon rules-based policymaking, we suggest downplaying enforceability—i.e. the role of formal sanctions through enforcement—and enhancing the reputational costs of breaching rules. At the limit, the rule could consist of a simple quantitative benchmark for a key fiscal indicator. To boost reputational effects, independent fiscal councils should focus on debunking the “fiscal alchemy,” clearing the public debate from partisan smokescreens, and fostering popular support for sound fiscal policies.     

Monetary and fiscal policy transmission in Poland

This paper combines a fiscal structural vector-autoregression (SVAR) with a monetary SVAR for the Polish transition economy. Data are constructed from scratch in order to account for features of the transition economy and for delays in implementing legislated government spending and tax changes (fiscal foresight). For monetary policy, we find no price puzzles in the combined SVAR. Also, fiscal foresight variables have no statistically significant effects. We calculate an initial government spending multiplier of 0.70, which later peaks at 1.61 for the cumulative multiplier. This multiplier is much larger than multipliers estimated in previous studies not combining fiscal and monetary policy, where they were found to be close to zero. On the other hand, the tax multiplier is generally near zero in our study. We demonstrate the importance of combining fiscal and monetary transmission mechanisms when assessing the effects of government macroeconomic policies.     

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.     

Debt, interest rates, and integration of financial markets

It is commonly believed that higher budget deficits raise interest rates. However, these crowding out effects of increasing public debt have usually been found to be small or non-existent. One explanation is that on globalised bond markets interest rate differentials are offset due to financial integration. This paper tests crowding out, and measures the degree of integration of government bond markets, using spatial modelling techniques. Our main finding is that the crowding out effect of public debt on domestic long term interest rates is small: a 1% increase in the debt ratio pushes up domestic rates by 2 pp at most. Financial integration implies an important spillover effect via international bond markets, but only between OECD, and in particular EU, countries. The feedback effect from these markets on long term interest rates is as important as the domestic crowding out effect of higher public debt. Emerging markets are not as well integrated into international capital markets, causing a stronger crowding out effect.     

Balance sheet changes and the impact of financial sector risk-taking on fiscal multipliers

We analyse implications of financial sector dynamics for fiscal expenditure multipliers in recessionary conditions. A new stock-flow consistent model is developed in which a financial sector with four financial instruments is integrated with the real sector. The transmission of policy innovations occurs through balance sheet effects. Higher government expenditure increases aggregate demand in the economy. This reduces the perceived probability of default on financial institutions’ loans, increases asset valuations, and leads financial institutions to reduce interest rate spreads. Expectations of higher future wealth and a reduction in credit constraints supports consumption growth. Stronger balance sheets across institutions and lower interest rates increase investment. The interaction between growth and balance sheet valuations creates financial accelerator effects though its impact on financial sector risk-taking. Inflows of foreign savings can increase the multiplier further than would be the case in a closed economy constrained by domestic savings. The results show that fully modelling interactions between real and financial sectors generates fiscal multipliers higher than have been found for South Africa in other types of model.     

Cross-country evidence on determinants of fiscal policy effectiveness: the role of trade and capital flows

This article studies the determinants of size differentials between fiscal multipliers in countries around the world, both advanced and developing economies. We introduce variables not considered before for explaining multiplier size differentials, such as capital flows and the openness of capital markets, while controlling for domestic conditions and exchange rate regimes. We also disaggregate GDP into its main components in order to identify the channels through which external and internal factors can influence GDP after a change in fiscal policy. Our results point to the existence of a new channel through which fiscal policy effectiveness is affected. Capital flows, especially FDI flows, play an important role in determining the sizes of fiscal multipliers, and a country’s external conditions largely explain GDP changes after fiscal expenditure shocks. Our results also point towards a strong link between a country’s international position and its real economy.     

Demographic trends and international capital flows in an integrated world

This paper examines the impact of projected demographic trends on international capital flows. The analysis builds upon a ten-region overlapping generations' model of the world economy where capital is mobile across regions. Results show that, over the first half of the century, emerging regions will finance the demand of capital coming from the developed world where population aging is relatively advanced. In particular, the findings suggest that in the coming decades China will be the world's main creditor region. However, in the second half of the century, India will take over this leading position because of the predicted decline in the Chinese labor force. An additional analysis demonstrates that the economic consequences of demographic changes depend on the degree of capital market integration between regions.     

State-dependent fiscal multipliers in NORA - A DSGE model for fiscal policy analysis in Norway

We develop a novel medium-scale DSGE model, called NORA, for fiscal policy analysis in Norway. NORA contains a sheltered and exposed sector allowing us to model wage bargaining between a labor union and the exposed sector, reflecting Scandinavian wage formation institutions. Wages are subject to a downward nominal wage rigidity (DNWR). Inspired by many countries' fiscal policy responses to the Great Recession and the coronavirus pandemic, we investigate the model's ability to generate state-dependent fiscal multipliers. We find, that both the zero lower bound on nominal interest rates and DNWR individually can account for higher fiscal multipliers during recessions. In joint presence, however, the existence of DNWR reduces the multiplier at the ZLB. Moreover, the DNWR significantly relaxes the paradox of toil at the ZLB. We show that the state-dependency is robust to alternative assumptions about the origin of the recession, the nature of the fiscal stimulus and its financing source.     

Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers

The paper examines simple monetary and fiscal policy rules consistent with determinate equilibrium dynamics in the absence of Ricardian equivalence. Under this assumption, government debt turns into a relevant state variable which needs to be accounted for in the analysis of equilibrium dynamics. The key analytical finding is that without explicit reference to the level of government debt it is not possible to infer how strongly the monetary and fiscal instruments should be used to ensure determinate equilibrium dynamics. Specifically, we identify bifurcations associated with threshold values of steady-state debt, leading to qualitative changes in the local determinacy requirements.     

Welfare and equity impacts of cross-border factor mobility in Bangladesh: A general equilibrium analysis

We develop a dynamic computable general equilibrium model with cross-border factor mobility to assess the impacts of a foreign wage shock and the effects of counteractive policy measures in Bangladesh. The model features migration of workers and foreign direct investment (FDI) in the ready-made garments (RMG) sector. Our simulation results show that returning migrants induced by a foreign wage fall would reduce household welfare by lowering wages and increasing unemployment, particularly for unskilled workers in the domestic labor market. To counteract this negative shock, FDI promotion in the RMG sector and a human-capital development program are considered. The former policy minimizes the negative impacts of the foreign labor market shock, while a combination of both policies is more equitable.     

Growth and inequality in an endogenous fiscal policy model with taxes on labor and capital

I study an economy where individuals have different initial endowments and fiscal policy is decided by majority voting. Public investment is financed by two flat rate taxes, one on labor income and the other one on capital income. The model shows a positive (negative) correlation between growth and the tax rate on labor (capital) income and a negative (positive) correlation between the tax rate on labor (capital) income and inequality. The results reconcile the theory with empirical evidence.     

Social status, human capital formation and super-neutrality in a two-sector monetary economy

In this paper, we study how social status affects the impact of monetary policy on the long-run growth rate in a two-sector monetary economy with human capital accumulation, and find that the super-neutrality of money, with regard to the growth rate of the economy depends on the formation of human capital. In an economy with Lucas-type human capital formation, money is super-neutral; however, for an economy in which both physical and human capital are used as inputs for human capital accumulation, the money growth rate will have a positive effect on the long-run economic growth rate. The existence, uniqueness and saddle-path stability of balanced-growth equilibrium are also examined.     

Specification choice and robustness in CGE trade policy analysis with imperfect competition

In order to contribute to a more comprehensive understanding of the robustness of the quantitative results of applied trade policy simulations to variations in the assumptions about firm conduct, this article provides a systematic synopsis of alternative formulations of imperfectly competitive supply behaviour in applied general equilibrium trade models and examines the sensitivity of simulated trade policy effects to the specification choice and calibration strategy within a prototype multi-country model. The analysis suggests in particular, that simulation results are generally far more sensitive to numerical specification choices at the calibration stage, than to the prior choice of firm conduct specification.     

Economic policy uncertainty in the US and China and their impact on the global markets

The recent US-China trade conflict has caused substantial uncertainty in the global markets. What is the rationale of this conflict? Is the rising of Chinese economy imposing a realistic threat to the US-led post-war international system? Using economic policy uncertainty in each of these two key global economic players as a measure of policy stance, this paper builds a time series model following Diebold and Yilmaz (2014) to estimate the influence of both the US and China on several key international markets, namely, stock, credit, energy and commodity markets. We find that, although China has become more influential, the US's dominant position still holds in all the markets. The results suggest that concerns regarding China's competition with the US in shaping the global world order are more likely to be driven by political factors rather than economic motives.     

Climate policy in Western Europe and avoided costs of air pollution control

Abatement of CO₂ emissions will be accompanied by reduced air pollutant emissions such as particulate matter (PM), SO₂, and NO_x. This, in turn, will reduce the need for end of pipe (EOP) pollution control technologies to meet future air quality targets. This dynamic could put more stringent air quality goals within reach, and increase the political feasibility of climate policy. This paper presents a CGE model that has been modified to include the emissions and EOP abatement of PM, SO₂, and NO_x from stationary sources in the EU-17. Emissions of pollutants are modeled as fixed-factor complementary inputs to their associated source. Abatement in each sector is modeled as a substitution between the pollutants and discrete abatement technologies, each of which is sector-specific and characterized by a marginal abatement cost and technical capacity constraint. Scenarios are run to 2020, to assess the costs and co-benefits of simultaneous air quality and climate policies. We find that under the Kyoto Protocol in 2010, the welfare cost of pollution control is reduced by 16% compared to the baseline, effectively offsetting the cost of CO₂ abatement by 15%. The co-benefit results depend heavily on policy choices, and their magnitude relative to total costs is likely to decline as greenhouse targets become more ambitious. In our scenarios, pollution control cost savings range from 1.3 to 20% in 2020, yielding a climate cost offset range of 0.2 to 3.9%. The CO₂ credit imports allowed by the EU via the Clean Development Mechanism (CDM) offer a total savings of $9.7bn in 2020, but only need to be compensated by an additional $0.3–0.4bn in domestic pollution control from stationary sources.     

Trend inflation and macroeconomic stability in a small open economy

This paper estimates a small open economy New Keynesian model for Australia with positive trend inflation while allowing for multiple equilibria. We first show the extent to which positive trend inflation can shrink the determinacy region. We then conduct a Bayesian estimation over two separate periods: from 1983Q1 to 1993Q1, covering the pre-inflation-targeting regime, and from 1993Q2 to 2018Q4, covering the inflation-targeting regime. We find that Australian monetary policy before the adoption of inflation-targeting permitted multiple equilibria and self-fulfilling inflation expectations to arise, resulting in exacerbated macroeconomic volatility. The implementation of inflation-targeting in Australia in the early 1990s successfully eradicated equilibrium multiplicity and sunspot shocks, and thereby drove the economy towards greater stability.     

The dynamic effects of monetary policy and government spending shocks on unemployment in the peripheral Euro area countries

In this paper we study the response of unemployment to monetary policy and government spending shocks in the peripheral Euro-area countries. By applying the structural near-VAR methodology, we jointly model area-wide and national variables. Our main finding is that fiscal multipliers vary across countries and the results are consistent with the prediction of the standard New Keynesian model only in Italy and Greece. Instead, in Ireland, Portugal and Spain increases in government spending are recessionary. Thus we find that Keynesian results of fiscal policy seem to prevail in high public-debt countries, whereas non-Keynesian outcomes seem to characterize high private-debt countries. As for the monetary policy shock, we find that it plays an important role, jointly with the other area-wide shocks, as a long-term driver of national unemployment.     

Fiscal devaluation and economic activity in the EU

In the aftermath of the global financial crisis, a fiscal devaluation (hereafter, FD), understood as a shift in taxation from labour to consumption, has been debated as a possible tool for restoring competitiveness, particularly in peripheral countries of the Eurozone. We contribute to this debate. Based on a set of panel and spatial panel models for the EU 27 over the period 1995–2014, we find that FD works, especially where economic activity is heavily subdued and in sectors more exposed on external competition. FD increases value added in exports, improves net exports, accelerates GDP and employment growth, and decelerates growth in labour costs. These effects are nonlinear; they are stronger in the members of the Eurozone and weaker in countries with either more coordinated or more centralised wage bargaining processes or more generous unemployment benefits. The magnitude of these effects is dampened by strict regulatory barriers: they are weaker in countries with higher barriers to entrepreneurship, trade and investment. Most importantly, FD is not a beggar thy neighbour policy, at least in the EU. In our sample, the aggregate demand (‘cooperative’) effect of unilateral FD, which is beneficial for neighbouring countries, outweighs by far the expenditure switching (‘competitive’) effect, which comes at the expense of other countries’ competitiveness. FD implemented in one country can benefit other countries, provided that they are strongly integrated in global value chains. These findings are robust to changes in the estimation methods, the sample composition, the set of explanatory variables and the selection of a spatial weight matrix.     

Monitoring Job Offer Decisions,Punishments, Exit to Work,and Job Quality

Unemployment insurance systems include the monitoring of unemployed workers and punitive sanctions if job search requirements are violated. We analyze the causal effect of sanctions on the ensuing job quality, notably on wages and occupational level. We use Swedish data and estimate duration models dealing with selection on unobservables. We also develop a theoretical job search model that monitors job offer rejection versus job search effort. The empirical results show that, after a sanction, the wage rate is lower and individuals move more often to a part‐time job and a lower occupational level, incurring human capital losses.