Slides

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A survey of the effects of
discretionary fiscal policy
Stockholm, 29 January 2008
Roel Beetsma
University of Amsterdam, CEPR and CESifo
Active fiscal policy is regaining
popularity…
• Fiscal stimulation packages to revive the Japanese
economy
• Most recently in the U.S.
– Total of 150 billion
– 100 billion lump-sum transfers
– 50 billion business tax cuts
2
What are the effects?
• Theoretical
– Closed economy
– Open economy
• Empirical effects
– “Internal” variables
– Open economy
• Own estimates for the EU
• Many different potential instruments
• Wide variations in findings
3
Theory – closed economy
• Standard textbook model: IS – LM
– Short-run model: price level fixed
– Goods market: interest rate  → investment  →
output  to restore equilibrium
– Money market: interest rate  → money demand  →
output  to restore demand (and equilibrium)
– Fiscal expansion → demand  → given interest rate,
output  to restore equilibrium
• Problems IS-LM
– Ad hoc: no optimisation
– Consequences of fiscal expansion for debt (hence,
4
future taxes) neglected
Fiscal expansion in the IS-LM model
Interest rate
IScurve
LMcurve
Output
5
Theory – closed economy
• Neo-classical:
– Government spending  → (future) taxes  (“wealth
effect”) → output , consumption  and labour supply
 → real wage  and investment 
• New-Keynesian (with price rigidity)
– Wealth effect → real wage 
– Government spending  → goods demand  → for
given price, output  → labor demand  → real wage 
– Overall real wage effect ambiguous
• Consumption still 
– Additional imperfection needed to strengthen link
disposable income and consumption (e.g. credit
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constraint)
Theory – open economy
• Mundell-Fleming
• Flexible exchange rate
– Fiscal expansion → shifts IS out → rH > rF →
capital inflow → e.r. appreciates → net exports 
→ IS shifts back → output unchanged
• Fixed exchange rate
– Fiscal expansion → shifts IS out → rH > rF →
capital inflow → money supply  to prevent exch
rate appreciation → output higher
• Same disadvantages as IS-LM
7
Theory – open economy
• Various factors are relevant:
–
–
–
–
–
–
–
–
Neo-classical vs new-Keynesian (price rigidities)
Credit restrictions / non-Ricardian consumers
Shock persistence (size of wealth effect)
Market completeness (possibilities for risk-sharing)
Small or large open economy
Home bias in spending
Elasticity of substitution domestic and foreign goods
Degree of openness of economy (amount of international
trade)
8
Empirics – “internal” effects
• Blanchard & Perotti (2002) for U.S.
– govt purchases  → output  (multiplier close to
unity), consumption  and investment 
– net taxes  → output  and investment 
• Mountford & Uhlig (2005) for U.S.
– govt purchases  → small positive effect on output and
consumption; negative effect on investment; costly
effect of higher future taxes
– tax-cut best way to stimulate economy
• Romer and Romer (2007): official documents to
identify “exogenous” legislated tax changes
– 1% of GDP rise in tax revenues → 3% fall in GDP ;
2.6% fall in consumption
9
Empirics – open economy
• Kim and Roubini (2004) for U.S.: budget deficit 
→ real exch rate depreciation and current account
improvement
• Müller (2006) find increase in net exports for U.S.
• Monacelli and Perotti (2006) and Ravn et al. (2007)
for Australia, Canada, U.K. and U.S.: govt
purchases  → cons , output , trade balance ,
real exch rate depreciation
• Lane and Perotti (1998, 2003): wage govt cons 
→ undermines competitiveness traded sector →
trade balance  , especially under flex exch rates
10
• Composition of fiscal impulse important!
Own estimates for EU
•
•
•
•
•
Following Beetsma et al. (2008, JEEA)
Panel SVAR approach
14 EU countries
Period 1970-2004, annual data
Estimate system with government
purchases, cyclically-adjusted net taxes (tax
– transfers), exports, output, imports, real
effective exchange rate (fall = appreciation)
• All real and in natural logarithms
11
Impulse responses after a government purchases shock
Government spending (g)
Import (m)
6.0
3.0
4.0
2.0
2.0
1.0
0.0
0.0
-2.0
-1.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
7
8
9
10
7
8
9
10
7
8
9
10
7
8
9
years after shock
Cyclically adjusted net taxes (nt)
Real effective exchange rate (reer)
2.0
0.5
0.0
1.0
-0.5
0.0
-1.0
-1.0
-1.5
-2.0
-2.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
years after shock
Export (x)
Budget balance (constructed)
1.0
0.5
0.0
0.0
-1.0
-0.5
-2.0
-1.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
years after shock
Output (y)
Trade balance (constructed)
2.0
0.5
1.5
0.0
1.0
-0.5
0.5
-1.0
0.0
-0.5
-1.5
0
1
2
3
4
5
years after shock
6
7
8
9
10
0
1
2
3
4
5
years after shock
6
10
12
Findings
• 1% of GDP increase in government purchases
–
–
–
–
–
–
–
–
–
Impact increase in GDP is 1.2%
Peak rise is 1.6%
Cyclically-adjusted net taxes fall
Exports rise (domestic prices rise relative to foreign)
Imports rise
Real effective exchange rate appreciates
Primary budget falls by 0.5% on impact, -0.8% peak
public budget falls by 0.7% on impact
“twin deficits”
13
Closed versus open economies
• Split based on average over time of
(Exports+imports)/GDP
• Closed: Finland, France, Germany, Greece,
Italy, Spain, U.K.
• Open: Austria, Belgium, Denmark, Ireland,
The Netherlands, Portugal and Sweden
• More “leakage effects” in open economies?
14
“Closed” EU countries
Government spending (g)
Import (m)
6.0
3.0
4.0
2.0
2.0
1.0
0.0
0.0
-2.0
-1.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
7
8
9
10
7
8
9
10
7
8
9
10
7
8
9
years after shock
Cyclically adjusted net taxes (nt)
Real effective exchange rate (reer)
3.0
1.0
2.0
0.0
1.0
-1.0
0.0
-2.0
-1.0
-2.0
-3.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
years after shock
Export (x)
Budget balance (constructed)
2.0
0.5
1.0
0.0
0.0
-1.0
-0.5
-2.0
-3.0
-1.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
years after shock
Output (y)
Trade balance (constructed)
3.0
0.5
2.0
0.0
1.0
-0.5
0.0
-1.0
-1.0
0
1
2
3
4
5
years after shock
6
7
8
9
10
0
1
2
3
4
5
years after shock
6
10
15
“Open” EU countries
Government spending (g)
Import (m)
6.0
4.0
4.0
2.0
2.0
0.0
0.0
-2.0
-2.0
-4.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
7
8
9
10
7
8
9
10
7
8
9
10
7
8
9
16
10
years after shock
Cyclically adjusted net taxes (nt)
Real effective exchange rate (reer)
2.0
1.0
0.0
0.0
-2.0
-1.0
-4.0
-2.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
years after shock
Export (x)
Budget balance (constructed)
1.0
0.5
0.0
0.0
-0.5
-1.0
-1.0
-2.0
-1.5
-3.0
-2.0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
years after shock
4
5
6
years after shock
Output (y)
Trade balance (constructed)
2.0
0.5
0.0
1.0
-0.5
0.0
-1.0
-1.0
-1.5
-2.0
-2.0
0
1
2
3
4
5
years after shock
6
7
8
9
10
0
1
2
3
4
5
years after shock
6
Findings:
• Output impact closed 1.43
• Output impact open 0.83
• Normalised responses imports or exports:
divide own response by response of output
• Normalised import response closed vs open
is 0.72 vs 0.49
• Normalised export response closed vs open
is -0.41 vs -0.99
• Larger trade balance deterioration for open
• Stronger and longer-lasting public budget
deterioration for open
17
Conclusions
• Bulk of evidence consistent with positive
effect net tax  or government purchases 
on output and consumption
• Output cost of future tax increase may
dominate gain of government purchases rise
• Strong disagreement about magnitudes of
effects
• Empirical analysis hampered by
– Identifying truly exogenous shocks
– Anticipation effects
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Conclusions
• Active fiscal stabilization policy seems
beyond capabilities of governments
– Uncertainty about size (often even sign) of effects
– Time lag between identification slowdown and
implementation of measures
– Current macroeconomic situation difficult to
measure (large data revisions).
• Fatas and Mihov (2003): discretionary fiscal
policy induces macro-economic instability,
which, in turn, affects growth negatively
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Conclusions
• In open economies (Sweden) a substantial part
of increase in government purchases leaks away
• Effect of increase in government purchases
unevenly distributed → export sectors in
particular hurt, because competitiveness 
• Best is to let automatic stabilisers work freely
– However, they do not distinguish source of shock,
nor whether it is temporary or permanent
– Complement with automatic link between debt and
taxes or cyclically adjusted primary deficit
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