Compatibility between monetary and fiscal policy under EMU

The debate over the Stability and Growth Pact (SGP) as a part of European Monetary Union, has highlighted the need to assess the extent to which fiscal policies of union members should be constrained as a pre-requisite for price stability within the union. In this paper, we develop a two country open economy model, where each country has overlapping generations of finitely lived consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure stability of the real debt stock is greater when consumers are not infinitely lived. In principle, this allows for some compensating behaviour between governments, but we show that the scope for compensation is limited. The monetary authority can abandon its active targeting of inflation to stabilise the debt of at most one fiscal authority, and any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.     

Monetary and Fiscal Policy Rules in the EMU

Abstract. This paper studies the design and effects of monetary and fiscal policy in the euro area. To do so, a stylized two‐region model of monetary and fiscal policy rules in the EMU is built. We analyse how monetary and fiscal rules affect the adjustment dynamics in the model. Both the effects on the individual countries and on the EMU aggregate economy are studied. Three aspects play an important role in the analysis: (i) the consequences of alternative monetary and fiscal policy rules, (ii) the consequences of asymmetries between EMU countries (asymmetries in macroeconomic shocks and macroeconomic structures), and (iii) the role of alternative degrees of backward‐ and forward‐looking behaviour in consumer decisions and inflation expectations.     

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

Using 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.     

Fiscal deficits and the socioeconomic consequences of rebalancing: Insights from a TVP-VAR with stochastic volatility

This article connects two salient economic features: (i) Fiscal shocks have asymmetric effects across business cycle phases (Gechert, Horn, & Paetz, 2019); (ii) the unemployment-output trade-off is time varying and may be unstable. The intertwined dynamic behaviour of fiscal deficit shocks and the unemployment-output trade-off is studied in this article using a time-varying parameter (TVP) vector autoregression (VAR) with stochastic volatility techniques applied to the analysis of data from Canada, France, Germany, Japan, Spain, Sweden, United Kingdom and the United States of America. We confirm the trade-off heterogeneity across country, and its time-varying nature across time, showing in addition its fluctuation around a long-run reference value. We document significant short-run impacts of fiscal shocks on the unemployment-output trade-off which, based on the experience of the Global Financial Crisis, becomes larger in periods of economic turmoil. Policy-wise, the rebalancing of public finances may have unexpected adverse effects on job creation if implemented during slumps, precisely when the labour market sensitivity with respect to the performance of the product market is likely to be more acute. This message is particularly relevant in the aftermath of the Covid-19 pandemic.     

The effects of fiscal spending shocks on the performance of simple monetary policy rules

We examine the effects of fiscal shocks on the performance of alternative monetary policy rules in a small dynamic general equilibrium framework. We explicitly consider the interaction between fiscal and monetary policy rules which may be present in the real world. We use a simple specification for the fiscal policy rule and various specifications for the (simple) monetary policy rule. Our analysis suggests that some form of flexible inflation targeting regime would perform well in response to fiscal shocks compared to other forms of policy regimes.     

Debt and deficit fluctuations and the structure of bond markets

We analyse the implications of optimal taxation for the stochastic behaviour of debt. We show that when a government pursues an optimal fiscal policy under complete markets, the value of debt has the same or less persistence than other variables in the economy and it declines in response to shocks that cause the deficit to increase. By contrast, under incomplete markets debt shows more persistence than other variables and it increases in response to shocks that cause a higher deficit. Data for US government debt reveals diametrically opposite results from those of complete markets and is much more supportive of bond market incompleteness.     

Fiscal shocks, output dynamics and macroeconomic stability: an empirical assessment for Austria (1983–2002)

We investigate the dynamic effects of discretionary fiscal policy in Austria over the period 1983:1 to 2002:4. A structural vector autoregressive (VAR) analysis, using the identification strategy suggested by Blanchard and Perotti (2002, Q J Econ 117(4):1329–1368), suggests that tax shocks have a negative effect on output, consumption, and investment. Spending shocks have a positive effect but are crowded out to a large extent after a few years. We then estimate ARCH models for output growth and inflation with the fiscal shocks included as explanatory variable in the variance equation. In line with recent cross-country studies there is evidence for a destabilizing role of discretionary fiscal policy.     

EU fiscal stance vulnerability: Are the old members the gold members?

This paper investigates the effect of aggregate shocks on the fiscal stance of the EU, and of its old (OMS) and new (NMS) member states over a business cycle. The fiscal stance is measured by the government deficit. To study the impact of aggregate shocks, we use impulse responses derived from a pooled structural vector autoregression model estimated on annual panel data. We find that the fiscal deficits of OMS could be vulnerable to discretionary changes in government expenditures and revenues. In contrast, the fiscal stance of NMS shows vulnerability to GDP shocks, because the increase in revenues after a positive GDP shock is often outpaced by greater expenditure increases in NMS. The estimated fiscal vulnerabilities stem from disproportionate policy responses concerning government expenditures and a lacking discipline to control pro-cyclical fiscal spending. Our findings for the EU thus support application of fiscal rules focused on government expenditure rather than other fiscal variables.     

Noisy fiscal policy

This paper investigates the macroeconomic effects of fiscal policy in a setting in which private agents receive noisy signals about future shocks to government expenditures. We show how to empirically identify the relative weight of news and noise shocks to government spending and compute the level of noise for Canada, the UK and the US. We then investigate the quantitative implications of imperfect fiscal policy information using a medium-scale DSGE model. We find that when the government seeks to implement a persistent change in expected public spending, the existence of noise (as estimated using actual data) implies a sizable difference in fiscal multipliers compared to the perfect fiscal foresight case.     

Measuring fiscal spillovers in EMU and beyond: A Global VAR approach

This paper identifies and measures fiscal spillovers in the EU countries empirically using a global vector autoregression (GVAR) model. Our aim was to look at the sign and the absolute values of fiscal spillovers in a countrywise perspective and at the time profile (impulse response) of the impacts of fiscal shocks. We find moderate spillover effects of fiscal policy shocks originating in Germany and France. However, there is significant variation regarding the magnitude of the spillovers on individual destination countries and country clusters. Furthermore, we find some evidence that German or French fiscal spillovers are stronger on EMU than on non‐EMU countries.     

FISCAL POLICY AND ASSET PRICES

We analyse the impact of fiscal policy on asset prices using a panel vector auto‐regressive (PVAR) approach and quarterly data for ten industrialized countries. We find that positive fiscal shocks lead to a temporary fall in stock prices and a gradual and persistent decrease in housing prices. The empirical findings also point to: (i) a contractionary effect of fiscal policy on output in line with the existence of crowding‐out effects and the deterioration of credit conditions; (ii) a weakening of the effectiveness of fiscal policy in recent times; (iii) a more persistent response of asset prices for countries with a lower degree of openness; (iv) a larger impact of fiscal policy on asset prices for small countries; (v) a close link between the responsiveness of asset prices to fiscal policy and the government’s size; (vi) an increase of the sensitivity of asset prices to fiscal policy shocks following the process of financial deregulation and mortgage liberalization; and (vii) significant fiscal multiplier effects in the context of severe housing busts. Finally, the evidence suggests that changes in equity prices may help governments towards consolidation of public finances.     

The macroeconomic effects of fiscal policy

We investigate the macroeconomic effects of fiscal policy using a Bayesian Structural Vector Autoregression (B-SVAR) approach. We identify fiscal policy shocks via a partial identification scheme, but also: (i) include the feedback from government debt; (ii) look at the impact on the composition of output; (iii) assess the effects on asset markets; (iv) use quarterly data; and (v) analyse empirical evidence from the US, the UK, Germany and Italy. The results show that government spending shocks, in general, have a small effect on Gross Domestic Product (GDP); lead to important ‘crowding-out’ effects; have a varied impact on housing prices and generate a quick fall in stock prices. Government revenue shocks generate a mixed effect on housing prices and a small and positive effect on stock prices. The empirical evidence also suggests that it is important to explicitly consider the government debt dynamics in the model.     

Swedish Postwar Business Cycles: Generated Abroad or at Home?

The relative importance of foreign and domestic shocks for the Swedish postwar business cycle is examined in a neoclassical stochastic growth model of a small open economy. Since recent research has shown that fiscal policy shocks may be important for business cycles, I extend previous work in the literature by allowing for stochastic fiscal policy. It is found that the introduction of fiscal policy improves the empirical fit of the model, although not significantly so when hours worked are detrended with the HP filter. The results suggest that domestic shocks are more important than foreign shocks for output fluctuations. Among the domestic shocks, innovations in fiscal policy seem to have been more important than technology shocks during this period. Foreign shocks are very important for fluctuations in the real exchange rate and the current account.     

Monetary and Fiscal Policy-Makers in the European Economic and Monetary Union: Allies or Adversaries?

Optimal monetary and fiscal policies within the European Economic and Monetary Union (EMU) are determined by simulating a global model under alternative assumptions about the objective function of the European Central Bank (ECB) and about cooperation vs. non-cooperation between monetary and fiscal policy-makers and among the latter. The results show the high effectiveness of fixed rules in the presence of supply-side shocks and the usefulness of cooperative discretionary measures against demand-side shocks. More generally, cooperation among fiscal policy-makers in the EMU is nearly always superior to non-cooperative equilibrium solutions, yielding a strong case for the coordination of fiscal policies.     

Fiscal policy and private consumption in industrial and developing countries

This paper empirically studies the effects of fiscal policy shocks on private consumption. Further, it investigates if the initial financing needs of the government or previous fiscal deficits affect that relationship. We use yearly data between 1970 and 2000 for 40 countries, of which 19 are industrialized and 21 are developing countries. In general, the estimation results seem to indicate that government consumption shocks have Keynesian effects for both industrial and developing countries. In the case of tax shocks, the evidence is mixed. Furthermore, there is no evidence that favors the hypothesis of expansionary fiscal consolidations.     

Fiscal risk in a monetary union

We present a dynamic and quantitative model of a fiscal solvency crisis in a monetary union. Diverse fiscal policies, which are subject to fiscal limits and stochastic shocks, can threaten a monetary union. The fiscal limits arise due to distortionary taxation and political will. Stochastic shocks are random and could push a fiscally sound policy towards its limit. In equilibrium agents refuse to lend along a path which violates the fiscal limits, creating a fiscal solvency crisis. The dynamics leading to the crisis depend on the policy response to restore lending. We focus on two responses, default and policy switching. We simulate our model to quantify the probability of a fiscal solvency crisis in the European Monetary Union with fiscal variables at end of 2009 values. Our model predicts the Greek crisis which occurred and warns of an Italian one.     

Money,output and income velocity

This paper attempts to assess empirically the contribution of three structural shocks – monetary, institutional (financial and fiscal), and technological – to output and velocity fluctuations in the national bank era and the post-1973 period. To identify these shocks we impose only long–run restrictions, derived from a monetary growth model. We find that higher money growth increases (decreases) velocity in the first (second) period, depending crucially on the resulting changes in the transactions frequency. Credit–enhancing financial or expansionary fiscal shocks have a permanent positive effect on velocity and a himp–shaped effect on output, whereas technological shocks cause velocity to decrease in the short run and output to move to a permanently higher level.     

United we stand: on the macroeconomics of a Fiscal union

In this paper, we apply dynamic tracking games to macroeconomic policy making in a monetary union. We use a small stylized nonlinear two-country macroeconomic model of a monetary union for analyzing the interactions between two fiscal (governments: “core” and “periphery”) and one monetary (central bank) policy makers, assuming different objective functions of these decision makers. Using the OPTGAME algorithm, we calculate numerical solutions for cooperative (Pareto optimal) and non-cooperative games (feedback Nash). We show how the policy makers react to adverse demand shocks. We investigate the consequences of three scenarios: decentralized fiscal policies controlled by independent governments (the present situation), centralized fiscal policy (a fiscal union) with an independent central bank (pure fiscal union), and a fully centralized monetary and fiscal union. For the latter two scenarios, we demonstrate the importance of different assumptions about the joint objective function corresponding to different weights for the two governments in the design of the common fiscal policy. We show that a fiscal union with weights corresponding to the number of states in each of the blocs gives better results than non-cooperative policy making. When one bloc dominates the fiscal union, decentralized policies yield lower overall losses than the pure fiscal union and the monetary and fiscal union.     

Fiscal policy in a small open economy with cross-border labor mobility

The large and stable inflow of workers’ remittances through formal financial channels to developing countries prompted authorities to harness fiscal resources from this flow. This paper develops a macro-dynamic model of a small open economy with cross-border labor mobility emphasizing fiscal policy. The flow of remittances is the result of a household’s optimizing decision to migrate. We examine the macroeconomic responses to fiscal policies. First, we show that an economy with international migration is more resilient to demand shocks resulting from fiscal contraction. Second, the short-run association between remittances and domestic output depends on the sources of the shocks. Third, our results indicate that the equilibrium impact of a tax on remittances can be expansionary and welfare-improving when an economy is initially close to full employment. The presence of utility-enhancing government expenditure and a potential negative externality from over-allocation of labor abroad (over migration) justify the presence of distortionary taxes.     

What are the effects of fiscal policy on asset markets?

We investigate the link between fiscal policy shocks and asset markets. Our results show that spending shocks have: a positive and persistent effect on GDP in the U.S. and in the U.K., while for Germany and Italy, such impact is temporary; a positive and persistent effect on housing prices; a negative effect on stock prices; and mixed effects on the price level. A VAR counter-factual exercise suggests that fiscal shocks play a minor role in the asset markets of the U.S. and Germany, and substantially increase the variability of housing and stock prices in the U.K., while government revenue shocks have increased volatility in Italy.