Determinants of fiscal multipliers revisited

We generalize a simple New Keynesian model and show that a flattening of the Phillips curve reduces the size of fiscal multipliers at the zero lower bound (ZLB) on the nominal interest rate. The factors behind the flatting are consistent with micro- and macroeconomic empirical evidence: it is a result of, not a higher level of price rigidity, but an increase in the degree of strategic complementarity in price-setting – invoked by the assumption of a specific instead of an economy-wide labour market, and decreasing instead of constant-returns-to-scale. In normal times, the efficacy of fiscal policy and resulting multipliers tends to be small because negative wealth effects crowd out consumption, and because monetary policy endogenously reacts to fiscally-driven increases in inflation and output by raising rates, offsetting part of the stimulus. In times of a binding ZLB and a fixed nominal rate, an increase in (expected) inflation instead lowers the real rate, leading to larger fiscal multipliers. Conditional on being in a ZLB-environment, under a flatter Phillips curve, increases in expected inflation are lower, so that fiscal multipliers at the ZLB tend to be lower. Finally, we also discuss the role of solution methods in determining the size of fiscal multipliers.     

What drives the short-run costs of fiscal consolidation? Evidence from OECD countries

We investigate how the short-term effects of fiscal consolidation on output and employment vary with the state of the business cycle, monetary policy, public debt, the current account, and private credit. By examining the response of a large number of variables, we are also able to shed light on the transmission channels of fiscal policy. Our main finding is that short-term output multipliers are below unity, even in states in which multipliers are expected to be larger (eg when the output gap is negative or monetary policy tight). Key offsetting factors that reduce the size of multipliers and explain differences across states are the extent to which the external sector improves and monetary policy eases.     

Optimal monetary–fiscal policy in the euro area liquidity crisis

We build an euro-area level DSGE model featuring a liquidity shock in the sovereign bonds market to simulate the strong contraction in economic activity observed during the 2008–2009 crisis. In the model, a sudden deterioration of the liquidity property of sovereign bonds is associated with deep recession and deflation. Against this background we characterize optimal monetary and fiscal policy with full commitment. We find that the optimal policy contains three features: (i) the policy rate is lowered until hitting the zero lower bound (ZLB) and then is kept at the ZLB for more periods; (ii) a prolonged central bank’s balance-sheet expansion aimed at restoring the liquidity deteriorated; (iii) a counter-cyclical fiscal stimulus which offsets, to a large extent, the fall in private spending caused by the liquidity shock. Policy regimes involving (i), but not (ii) and (iii), are quite weak in stabilizing output gap and inflation. Monetary policy regimes such as full inflation-targeting or nominal GDP targeting perform remarkably well insofar as they are complemented with an optimally-implemented counter-cyclical fiscal policy. Our results tend to favour the view that, in case of recession, an euro-wide coordinated fiscal policy should supplement the role of the ECB in achieving its primary objective.     

FiMod — A DSGE model for fiscal policy simulations

This paper develops a medium-scale dynamic, stochastic, general equilibrium (DSGE) model for fiscal policy simulations. Relative to existing models of this type, our model incorporates two important features. First, we consider a two-country monetary union structure, which makes it well suited to simulate fiscal measures by relatively large countries in a currency area. Second, we provide a notable degree of disaggregation on the government expenditures side, by explicitly distinguishing between (productivity-enhancing) public investment, public purchases and the public sector wage bill. In addition, we consider a labor market characterized by search and matching frictions, which allows to analyze the response of equilibrium unemployment to fiscal measures. In order to illustrate some of its applications, and motivated by recent policy debate in the Euro Area, we calibrate the model to Spain and the rest of the area and simulate a number of fiscal consolidation scenarios. We find that, in terms of output and employment losses, fiscal consolidation is the least damaging when achieved by reducing the public sector wage bill, whereas it is most damaging when carried out by cutting public investment.     

Macroeconomic impacts of fiscal policy shocks in the UK: A DSGE analysis

This paper develops and estimates a new-Keynesian dynamic stochastic general equilibrium (DSGE) model for the analysis of fiscal policy in the UK. We find that government consumption and investment yield the highest GDP multipliers in the short-run, whereas capital income tax and public investment have dominating effect on GDP in the long-run. When nominal interest rate is at the zero lower bound, consumption taxes and public consumption and investment are found to be the most effective fiscal instruments throughout the analysed horizon, and capital and labour income taxes are established to be the least effective. The paper also shows that the effectiveness of fiscal policy decreases in a small open-economy scenario and that nominal rigidities improve effectiveness of public spending and consumption taxes, whereas decrease that of income taxes.     

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.     

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.     

On the size of fiscal multipliers: A counterfactual analysis

We point out that fiscal multipliers derived from SVAR-models include the predicted future path of policy instruments. After the initial shock, net taxes and government expenditures react to each other and are autocorrelated. In a counterfactual simulation, we report fiscal multipliers that abstract from these dynamic responses.     

Monetary policy and fiscal limits with no-default

This paper discusses monetary and fiscal policy interactions that stabilize government debt. Two distortions prevail in the model economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include a ceiling on the equilibrium debt-to-GDP ratio, zero or negative elasticity of tax revenues, and a political intolerance of raising tax rates. At the fiscal limit two mechanisms restore solvency: fiscal inflation, which reduces the real value of nominal debt, and open market operations, which diminish the size of government debt held by the private sector. Three regimes achieve this goal. In all regimes monetary policy is passive. In all regimes a muted tax response to government debt is consistent with equilibrium. The propensity of a fiscal authority to smooth output is found to determine what is an acceptable response (in the form of tax rate changes) to the level of government debt, while monetary policy determines the timing and magnitude of fiscal inflation. Impulse responses show that the inflation and tax hikes needed to offset a permanent shock to transfers are lowest under nominal interest rate pegs. In this regime, most of the reduction in the real value of government debt comes from open market purchases.     

Biases in fiscal multiplier estimates

The size of fiscal multipliers is intensively debated as large (small) multipliers provide arguments to expand (cut) public spending. We use data on multiplier estimates from over a hundred scholarly studies, and ask whether the national imprint and various incentives that the authors face can help explain the large observed variance in these estimates. We complement this meta-analytical data with information on economists’ personal characteristics collected from their biographies and through a self-conducted survey. Our evidence is consistent with the hypothesis that national background and policy orientation of researchers matter for the size of multiplier estimates. We only find weak support for the hypothesis that the interests of donors financing the research are relevant. Significant biases largely disappear for teams of international co-authors.     

Wage Rigidity,Inflation, and Institutions

We study the possible existence of downward nominal wage rigidity (DNWR) at wage growth rates different from zero in aggregate data. Even if DNWR prevails at zero for individual workers, compositional effects might lead to falling aggregate wages, while changes in relative wages combined with DNWR might lead to positive aggregate wage growth. We explore industry data for 19 OECD countries, over the 1971–2006 period. We find evidence for a floor on nominal wage growth at 6 percent in the 1970s and 1980s, at 1 percent in the 1990s, and at 0.5 percent in the 2000s. Furthermore, we find that DNWR is stronger in country‐years with strict employment protection legislation, high union density, centralized wage setting, and high inflation.     

Inflation and the fiscal limit

We use a rational expectations framework to assess the implications of rising debt in an environment with a “fiscal limit”. The fiscal limit is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes, so either an adjustment to fiscal spending or monetary policy must occur to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as over the timing of when the fiscal limit is hit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The distribution of outcomes for the path of future inflation has a fat right tail, revealing that only a small set of outcomes imply dire inflationary scenarios. Avoiding these scenarios, however, requires the fiscal authority to renege on some share of future promised transfers.     

To react or not? Technology shocks, fiscal policy and welfare in the EU-3

This paper develops a dynamic stochastic general equilibrium (DSGE) model to examine the quantitative macroeconomic implications of counter-cyclical fiscal policy for France, Germany and the UK. The model incorporates real wage rigidity and consumption habits, as the particular market failures justifying policy intervention. We subject the model to productivity shocks and allow policy instruments to react to the output gap and the debt-to-output ratio. A welfare analysis reveals that the most effective instrument-target combination is to use public consumption to stabilize the output gap. Moreover, welfare gains from counter-cyclical fiscal policy are much stronger in the presence of wage rigidities compared with consumption habits. Finally, since active policy and automatic stabilizers are substitutes, it is possible that relatively undistorted economies may be in need of countercyclical fiscal action due to inadequate automatic stabilizers.     

Monetary–fiscal policy interactions and fiscal stimulus

Increases in government spending trigger substitution effects—both inter- and intra-temporal—and a wealth effect. The ultimate impacts on the economy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes create a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between active and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model's predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act's implied path for government spending under alternative monetary–fiscal policy combinations.     

Asymmetric effects of fiscal policy in EU and OECD countries

In this article, we take account of an evaluation of the short- and medium-term effects of the transmission mechanism of fiscal policy in EU and OECD countries and their dependence on the state of the economy and fiscal behaviour. Our findings indicate that (i) across EU member states the impact of government spending on economic performance is larger in the accession than in core member states, (ii) since the onset of the economic/financial crisis the government spending multipliers have become larger in both core and accession EU member states, and (iii) a comparison with fiscal responses in the OECD countries shows robustness of our estimates. The conclusion implies that the austerity measures present a substantial drag for economic activity in accession EU countries. Thus, we may state that not considering the fiscal behaviour and state of the economy gives misleading fiscal multiplier effects, which in turn lead to the adoption of inappropriate fiscal measures that even worsen a country's economic situation.     

Identifying fiscal inflation

Fiscal theorists warn about the risk of future inflation as a consequence of fiscal imbalances in the US. Because actual inflation remains historically low and data on inflation expectations do not corroborate such risks, warnings for fiscal inflation are often ignored in policy and academic circles. This paper shows that a canonical NK-DSGE model enables identifying an anticipated component of inflation expectations that is closely related to fiscal policy. Estimation results suggest that fiscal inflation concerns have induced a 1.6%-points increase in long-run inflation since 2001. The model also rationalizes why data on inflation expectations do not reveal such concerns outright.     

Fiscal policy,macroeconomic performance and industry structure in a small open economy

We analyse how fiscal policy affects both the macroeconomy and the industry structure, using a multi-sector macroeconomic model of the Norwegian economy with an inflation targeting monetary policy. Our simulations show that the magnitude of the government spending and labour tax cut multipliers, whether monetary policy is active or passive, is comparable to what is found in the literature. A novel finding from our simulations is that the industry structure is substantially affected by an expansionary fiscal policy, as value added in the non-traded goods sector increases at the expense of value added in the traded goods sector. Moreover, expansionary fiscal policy reduces the mark-ups in the traded goods sector, while the mark-ups are roughly unchanged in the non-traded goods sector. The contraction of activity in the traded goods sector increases when monetary tightening accompanies the fiscal stimulus. Hence, we find that such a policy mix is likely to produce significant de-industrialization in a small open economy with inflation targeting.     

Multipliers of expected vs. unexpected fiscal shocks: The case of Korea

We compare the multipliers of expected and unexpected fiscal shocks. In doing so, we consider that the future path of fiscal policy is anticipated to some degree, and incorporate this characteristic into a news approach. We build a standard small open economy New-Keynesian DSGE model with a fully specified fiscal policy structure, and examine the Korean economy as an example of a small open emerging economy. We find that the present-value multiplier of the government consumption news shock in Korea is smaller than that of a corresponding surprise shock of the same magnitude, apart from the initial couple of years in the case of the output multiplier, and is consistently smaller in the cases of the consumption and investment multipliers. The present-value output multiplier of the government consumption news shock starts from about 0.72 and declines continuously to reach 0.16 after 40 years.     

Is fiscal expansion more effective in a financial crisis?

After the Great Recession, the Keynesian expansionary policy has been regarded as an effective measure, especially under imperfect financial market conditions. Among literature related to fiscal policy in financial crises, Fernández-Villaverde (2010) suggests that the fiscal policy multiplier increases in a financial crisis through the Fisher effect. However, we should note that the author simply compared the multiplier computed in the standard new Keynesian dynamic stochastic general equilibrium (DSGE) with that in the DSGE with financial accelerator settings. As the financial accelerator is considered effective during both financial crises and normal financial conditions, the author’s comparison should be considered insignificant for showing a greater multiplier in the financial crisis. In this study, to make the exact comparison, we first estimate parameters regarding the Fisher effect under each regime separately and then compute and compare the estimated fiscal multipliers using these 2 estimates in the same DSGE model. Using Japanese financial data that provide enough observations under the good and bad regimes of financial conditions, we find that fiscal multipliers are smaller in the bad regime than in the good regime.     

Does downward nominal wage rigidity dampen wage increases?

Focusing on the compression of wage cuts, many empirical studies find a high degree of downward nominal wage rigidity (DNWR). However, the resulting macroeconomic effects seem to be surprisingly weak. This contradiction can be explained within an intertemporal framework in which DNWR not only prevents nominal wage cuts but also induces firms to compress wage increases. We analyze whether a compression of wage increases occurs when DNWR is binding by applying Unconditional Quantile Regression and Seemingly Unrelated Regression to a dataset comprising more than 169 million wage changes. We find evidence of a compression of wage increases and only very small effects of DNWR on average real wage growth. The results indicate that DNWR does not provide a strong argument against low inflation targets.