Estimating the Real Effects of Fiscal Policy

There is both fierce theoretical and empirical debate as to the effects of policy interventions on the economy. Theoretically, the response is sensitive to the model used. Empirically, the endogenous nature of policy makes identification troubling, as do data issues. Given the large fiscal and monetary stimuli seen across the world in response to the global recession one would expect a degree of agreement across economists as to the size of policy multipliers, but this is certainly not the case. Movement towards a consensus view on the size and sign of policy multipliers requires convincing and robust empirical work. Work in the CEP is addressing empirical issues using:

Fiscal policy multipliers:

Ethan Ilzetzki, Enrique Mendoza and Carlos Végh study fiscal multipliers across different country groupings, creating a rich new data set to overcome data issues. They also estimate the multiplier in different situations - fixed / floating exchange rates, high / low existing government debt - allowing more target policy recommendations. A big hurdle in obtaining precise estimates of fiscal multipliers has been data availability.

Most studies have relied on annual data, which makes it difficult to obtain precise estimates as much o the action is at a higher frequency than the data. To address this shortcoming, they have put together a novel quarterly dataset for 44 countries, 20 high-income and 24 developing. Theory suggests differing responses to fiscal policy depending on the state of the economy and economic regime (especially monetary responses), so estimating a single fiscal multiplier for all states is not sensible. Instead they group data on similar countries and estimate the multiplier using the SVAR methodology using all of the data in this group, increasing the number of data points in use in each regression from roughly 40 to generally over 1,000. This has the added advantage that without such pooling only around 10 years of data would be available for each estimate. They find substantial variation in the size of the fiscal multipliers by category, with important policy implications:

1. The degree of exchange rate flexibility is a critical determinant of the size of fiscal multipliers. Economies operating under predetermined exchange rate regimes have long-run multipliers that are larger than one in some specifications, but economies with flexible exchange rate regimes have essentially zero multipliers. They find that the main difference between the response to government consumption in countries with different exchange rate regimes is in the degree of monetary accommodation to fiscal shocks. Their evidence thus supports the notion that the response of central banks to fiscal shocks is crucial in assessing the size of fiscal multipliers.
   
   
2. Openness to trade is another critical determinant. Economies that are relatively closed (whether due to trade barriers or larger internal markets) have long-run multipliers of around 1.3 to 1.4, but relatively open economies have negative multipliers. In economies with large proportions of trade to GDP the multiplier is statistically different from zero and from the multiplier in open economies. The multiplier in open economies is negative and significantly lower than zero both on impact and in the long run.
   
   
3. During episodes where the outstanding debt of the central government was high (exceeding 60 percent of GDP) the fiscal multiplier was not statistically different from zero on impact and was negative (and statistically different from zero) in the long run. Experimentation with a range of sovereign debt ratios indicated that the 60 per cent of GDP threshold, used for example by the Eurozone as part of the Maastricht criteria, is indeed a critical value above which fiscal stimulus may have a negative, rather than a positive impact on output in the long run.

Given increasing trade integration and the adoption of flexible exchange rate arrangements - particularly the adoption of inflation targeting regimes - their results cast doubt on the effectiveness of fiscal stimuli. Moreover, fiscal stimuli are likely to become even weaker, and potentially yield even negative multipliers, in the near future, because a large number of countries are now carrying very high public debt ratios. At the same time, their findings provide new evidence on the importance of fiscal-monetary interactions as a crucial determinant of the effects of fiscal policy on GDP.

For further reading please see

• "How Big (Small?) are Fiscal Multipliers?" [Full document in Adobe PDF] (Ethan Ilzetzki, Enrique G. Mendoza, Carlos A. Végh), CEP Discussion Paper 1016, October 2010