Ebook The Effects of Fiscal Policy on Consumption and Employment: Theory and Evidence
Compared to the large empirical literature on the effects of monetary policy, fiscal policy received much less attention in economic research until recently. This lack of attention was at odds with the fact that several key public debates on the role of fiscal policy were based on arguments eliciting the macroeconomic importance of government spending and taxation. The discussions around the Balanced Budget Amendment in the US, the deficit limits of the Growth and Stability Pact under EMU, or the possibility of having independent institutions running fiscal policy are all based on the assumption that fiscal policy is an effective tool for stabilizing business cycles fluctuations. The need for empirical evidence to elucidate the issues in these debates spurred a large body of new research, which can be loosely grouped in three categories. First, a group of economists focused on specific episodes, fiscal consolidations, to study the macroeconomic impact of large reductions in the budget deficit. The second line of research analyzed the stabilizing capability of fiscal policy variables, i.e. to what extend the tax and transfer system provides insurance against idiosyncratic regional shocks and how well it stabilizes macroeconomic fluctuations in the aggregate. Finally, the dynamic effects of discretionary fiscal policy on macroeconomic variables a typical issue in the large macroeconometric models of the 1960s and 1970s was recently revived within the framework of vector autoregressions in the work of Blanchard and Perotti (1999).
By investigating the effects of shifts in fiscal policy stance on economic activity, this paper contributes to the third strand of research outlined above. The goal of the paper is two-fold. First, we want to document some of the robust findings on the dynamic effects of variation in government spending on key macroeconomic variables. We believe that the reported empirical evidence will be helpful in current policy discussions. Second, we compare our empirical findings to the predictions of the real business cycle model. We use this model as a benchmark because of its popularity and more importantly because it illustrates clearly the mechanisms behind the main theoretical responses. In particular, we are interested in the response of consumption and employment to changes in government spending because the theoretical model has uniform qualitative predictions about the effects of fiscal policy on these two variables over a wide range of variations in the underlying assumptions. Moreover, the model consistently implies that the conditional correlation of consumption and employment must be negative – in-creases in government spending must increase hours worked and lead to a decline in consumption.
Focusing the analysis on the response of macroeconomic variables to an identified fiscal policy shock is a more restrictive test of the real business cycle model than the traditional methodology of matching unconditional moments to a model with a variety of shocks. As shown in Christiano and Eichenbaum (1992), some of the initial puzzles of RBC models can be resolved by the inclusion of additional sources of shocks. However, Gal? (1999) argues that even if the model can replicate the unconditional moments of the data, it may provide a distorted picture of the economy’s response to each of the shocks.
We compare our empirical results to a modification of the basic RBC model proposed by Ludvigson (1996). This model allows us to track the effects of deficit financed spending increases in a setup with distortionary taxes, which is arguably a more realistic representation of fiscal policy than the conventional lump-sum financing or the balanced budget policy rule. Thus we report a broader range of policy experiments than one can find in the prototypical RBC model. It is interesting to note that in addition to bringing the model’s setup closer to reality, the introduction of a government sector in the RBC model has been hailed as an important improvement in model’s ability to match the data. Christiano and Eichenbaum (1992) argue that without allowing for stochastic government spending, the standard real business cycle model cannot replicate the well-documented observation that average labor productivity and hours worked are only weakly correlated. The explanatory power of government spending in this context is derived from the fact that shifts in fiscal policy lead to changes in labor supply and thus to negative correlation between hours and productivity. This negative correlation can offset the high positive comovement between productivity and hours driven by technology shocks. Indeed, we show that following an increase in government spending real wages decline while labor supply increases. The mechanism behind this negative conditional correlation is exactly the same as the one driving the negative correlation between consumption and employment – the absorption of resources by the government requires that private agents increase their work effort and reduce their consumption. Thus, the improvement in the model’s fit in the direction of matching the Dunlop - Tarshis observation of low or negative correlation between real wages and hours creates as a by-product another puzzling result, namely the negative correlation between consumption and hours, which is in stark contrast to the empirical results in this paper. We document that in the data both employment and consumption increase after an increase in government spending.
The empirical evaluation of the fiscal policy is conducted using a vector autoregression framework. Some of the earlier work on fiscal policy has often relied on the cyclically-adjusted primary deficit as a measure of fiscal policy stance. Although the adjusted deficit does deliver information about current policy, it is inappropriate in dynamic macroeconometric analysis because none of the competing theories implies that spending increases and tax cuts have the same effect on the economy. In this paper we focus on the effects of changes in government spending. The primary reason for this rather restrictive focus is that alternative theories imply different economic dynamics following a change in government spending while having qualitatively similar predictions for the effects of changes in tax rates. Furthermore, our focus on the conditional correlation of consumption and employment requires that we identify only spending shocks.
One generic issue with fiscal policy VARs is the fact that both revenue and expenditure adjustments are often pre-announced. While in the case of monetary policy there is certain logic in focusing on unanticipated changes in policy stance, it is difficult to mechanically extend this logic to fiscal policy. Moreover, if pre-announced changes in policy stance do not vary systematically with general macroeconomic conditions, the VAR will be omitting important information and will be misspecified by not including anticipated changes in expenditure or revenue variables. We address this criticism in a sequence of robustness exercises that use official budget forecasts to augment the information set in the VAR thus accounting, at least partially, for anticipated fiscal policy.
Our results show that increases in government spending are expansionary with a multiplier larger than one, i.e. output increases more than one-to-one. When we compare our key results to a standard RBC model we find that the largest discrepancy between the model and the empirical results is the response of consumption. In the empirical estimations, the expansion in output is always accompanied by an increase in consumption. Although an RBC model can produce an expansion in output following an increase in government expenditures, as in Baxter and King (1993), consumption always decreases in response to an expansion in government spending because of the obvious negative wealth effects. The model also fails to capture the positive conditional correlation between the empirical response of employment and consumption following an increase in government spending. We argue that the negative correlation predicted by the RBC model is a general feature of a large class of dynamic general equilibrium models and it is difficult to reconcile this prediction with the data. The contribution of this paper is to focus attention on two conditional moments in the data that are in conflict with the theoretical predictions: the response of consumption and the correlation between consumption and employment responses.
The next section describes the econometric framework and reports results from a battery of VARs. Section 3 presents the benchmark general equilibrium model. Policy simulations based on this model are reported in Section 4. Section 5 compares the dynamics derived from the theoretical model to the empirical impulse responses from the VARs. The last section provides some concluding remarks.
Download
PDF Ebook The Effects of Fiscal Policy on Consumption and Employment: Theory and Evidence
Posted in :
