Ebook The Effects Of Fiscal Policy On Output And Debt Sustainability In The Euro Area: A Dsge Analysis
The severity of the global economic downturn coupled with weakened monetary policy transmission channels has prompted the extensive use of discretionary fiscal policy to support demand in many countries. Fiscal packages have varied in their size and their composition (OECD, 2009), yet there is little evidence in the literature on the effectiveness of fiscal policy at times of crisis, and in the current economic environment it is even scarcer. The impaired functioning of financial markets, strongly accommodative monetary policy and heightened uncertainty are likely to alter the fiscal policy impulse on economic activity. At the same time, a high level of borrowing may bear on sovereign bond interest rates and crowd out private demand. These factors are hard to quantify in the current circumstances, making it difficult to assess the effectiveness of fiscal policy as measured by the so-called fiscal multipliers.
While there have been attempts to investigate the effect of fiscal policy in situations where financial markets are impaired in a DSGE framework (e.g. Röger and in’t Veld, 2009), no work to our knowledge has tried to analyse the trade-off between the effects of expansionary fiscal policy on economic activity and the increase in government bond premia, which may crowd out public investment and consumption and lead to unsustainable debt levels. The analysis undertaken in this paper seeks to fill this gap. To this end, we model government bond rates as a function of fiscal positions. Modeling explicitly government bond rates during financial crises is particularly important for two reasons. First, the difference between short-term and long-term policy rates is more marked in times of financial crises (OECD, 2009). Second, financial crises are often characterised by a large increase in the fiscal deficit and debt levels, reflecting the associated output losses and discretionary fiscal policy responses, but also marked rises in government risk premia (Reinhart, 2009).
The model draws extensively on pre-existing DSGE models on a number of aspects (Smets and Wouters, 2003; Ratto et al., 2009). In particular, it considers a large closed economy with monopolistic product markets, a heterogeneous household sector with Ricardian and liquidity-constrained households, investment adjustment costs, prices and real wage persistence. Simulations are performed for a variety of fiscal instruments (government consumption, government investment, transfers, consumption taxes, taxes on wages and capital).
The key results of the paper are:
- Fiscal policy appears to be an effective tool to boost demand in the short-term , despite the associated rise in government bond spreads increase in response to a fiscal stimulus, that crowds out interest-sensitive demand components.
- The GDP impacts of fiscal policy vary across instruments. The largest short-term effect on GDP is found for an increase in public investment. A rise in public consumption also appears to sustain activity significantly, while a transfer to liquidity-constrained households has a more limited impact. Tax cuts would be in general less effective is supporting demand than spending measures. Among taxation measures, the strongest effects are attached to a cut in wage taxes.
- The euro area fiscal package introduced in the first half of 2009 in response to the financial crisis is found to boost GDP by 0.8 percentage point in 2009 and by 0.6 percentage point in 2010. Public debt would rise by 1.8 percentage points in 2010.
The rest of the paper is organised as follows. Section two describes the main features of the DSGE model. Section three examines the consequences of a government consumption shock. Section four discusses fiscal policy simulations using a range of policy instruments on the spending and revenue sides. Section five presents an estimate of how the 2009 fiscal package introduced in the euro area countries affects activity, inflation and public finances. Finally, section six concludes.
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