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Debt and the effects of fiscal policy

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Author Info
Carlo Favero
Francesco Giavazzi

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Abstract

A fiscal shock due to a shift in taxes or in government spending will, at some point in time, constrain the future path of taxes and spending, since the government’s intertemporal budget constraint will eventually have to be met. This simple fact is surprisingly overlooked in analyses of the effects of fiscal policy based on vector autoregressive models. We study the effects of fiscal shocks, keeping track of the debt dynamics that arise following a fiscal shock and allowing for the possibility that taxes, spending, and interest rates might respond to the level of the debt as it evolves over time. We show that the absence of a debt feedback effect can result in incorrect estimates of the dynamic effects of fiscal shocks. In particular, omitting an effect of fiscal shocks on long-term interest rates—a frequent finding in studies that omit a debt feedback—can be explained by the misspecification of these fiscal shocks. Using data for the U.S. economy and two alternative identification assumptions, we reconsider the effects of fiscal policy shocks, correcting for these shortcomings. We close the paper by observing that the methodology described by taking into account the stock-flow relationship between debt and fiscal variables to analyze the impact of fiscal shocks could also be applied to other dynamic models that include similar identities. The inclusion of capital as a slow-moving variable in the study of the relationship between productivity shocks and hours worked is one example.

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Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 07-4.

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Date of creation: 2007
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Handle: RePEc:fip:fedbwp:07-4

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Keywords: Debt ; Fiscal policy;

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  1. Mountford, A. & Uhlig, H., 2002. "What are the effects of fiscal policy shocks?," Discussion Paper 31, Tilburg University, Center for Economic Research. [Downloadable!]
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  2. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2007. "Are structural VARs with long-run restrictions useful in developing business cycle theory?," Staff Report 364, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  3. Roberto Perotti, 2007. "In Search of the Transmission Mechanism of Fiscal Policy," NBER Chapters, in: NBER Macroeconomics Annual 2007, Volume 22, pages 169-226 National Bureau of Economic Research, Inc.
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  4. Wendy Edelberg & Martin Eichenbaum & Jonas D.M. Fisher, 1999. "Understanding the Effects of a Shock to Government Purchases," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(1), pages 166-206, January. [Downloadable!] (restricted)
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  5. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output," The Quarterly Journal of Economics, MIT Press, vol. 117(4), pages 1329-1368, November. [Downloadable!] (restricted)
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  6. Fatás, Antonio & Mihov, Ilian, 2001. "The Effects of Fiscal Policy on Consumption and Employment: Theory and Evidence," CEPR Discussion Papers 2760, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  7. Giavazzi, Francesco & Jappelli, Tullio & Pagano, Marco, 2000. "Searching for Non-Linear Effects of Fiscal Policy: Evidence from Industrial and Developing Countries," CEPR Discussion Papers 2374, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  8. Craig Burnside & Martin Eichenbaum & Jonas Fisher, 2003. "Fiscal Shocks and Their Consequences," NBER Working Papers 9772, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Henning Bohn, 1998. "The Behavior Of U.S. Public Debt And Deficits," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 949-963, August. [Downloadable!] (restricted)
  10. Bagliano, Fabio C. & Favero, Carlo A., 1999. "Information from financial markets and VAR measures of monetary policy," European Economic Review, Elsevier, vol. 43(4-6), pages 825-837, April. [Downloadable!] (restricted)
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  11. Christina D. Romer & David H. Romer, 1989. "Does Monetary Policy Matter? A New Test in the Spirit of Friedman and Schwartz," NBER Chapters, in: NBER Macroeconomics Annual 1989, Volume 4, pages 121-184 National Bureau of Economic Research, Inc. [Downloadable!]
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  1. Lucia Alessi & Matteo Barigozzi & Marco Capasso, 2008. "A review of nonfundamentalness and identification in structural VAR models," Working Paper Series 922, European Central Bank. [Downloadable!]
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  2. Antonio Fatas & Ilian Mihov, 2009. "The Euro and Fiscal Policy," NBER Working Papers 14722, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Roberto Perotti, 2007. "In Search of the Transmission Mechanism of Fiscal Policy," NBER Working Papers 13143, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. C. Bianchi & M. Menegatti, 2007. "Rules versus discretion in fiscal policy," Economics Department Working Papers 2007-EP05, Department of Economics, Parma University (Italy). [Downloadable!]
  5. António Afonso & Ricardo M. Sousa, 2008. "Fiscal Policy, Housing and Stock Prices," Working Papers 2008/58, Department of Economics at the School of Economics and Management (ISEG), Technical University of Lisbon.. [Downloadable!]
    Other versions:
  6. Claeys Peter, 2008. "Estimating the effects of fiscal policy under the budget constraint," wp.comunite 0038, Department of Communication, University of Teramo. [Downloadable!]
    Other versions:
  7. Christopher Reicher, 2009. "Fiscal Taylor Rules in the Postwar United States," Kiel Working Papers 1509, Kiel Institute for the World Economy. [Downloadable!]
  8. Hess Chung & Eric M. Leeper, 2007. "What Has Financed Government Debt?," NBER Working Papers 13425, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  9. Kristie M. Engemann & Michael T. Owyang & Sarah Zubairy, 2008. "A primer on the empirical identification of government spending shocks," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 117-132. [Downloadable!]
  10. Ricardo M. Sousa & António Afonso, 2008. "The Macroeconomic Effects of Fiscal Policy," NIPE Working Papers 22/2008, NIPE - Universidade do Minho. [Downloadable!]
    Other versions:
  11. Felicity C Barker & Robert A Buckle & Robert W St Clair, 2008. "Roles of Fiscal Policy in New Zealand," Treasury Working Paper Series 08/02, New Zealand Treasury. [Downloadable!]
  12. Ricardo M. Sousa & António Afonso, 2009. "The Macroeconomic Effects of Fiscal Policy in Portugal: a Bayesian SVAR Analysis," NIPE Working Papers 3/2009, NIPE - Universidade do Minho. [Downloadable!]
    Other versions:
  13. Pereira, Manuel C, 2008. "Empirical evidence on the stabilizing role of fiscal and monetary policies in the US," MPRA Paper 17474, University Library of Munich, Germany, revised Sep 2009. [Downloadable!]
  14. Dario Caldara & Christophe Kamps, 2008. "What are the effects of fiscal shocks? A VAR-based comparative analysis," Working Paper Series 877, European Central Bank. [Downloadable!]
  15. Joseph P. Byrne & Norbert Fiess & Ronald MacDonald, 2008. "The Global Dimension to Fiscal Sustainability," Working Papers 2008_10, Department of Economics, University of Glasgow. [Downloadable!]
  16. Lane, Philip R., 2009. "A New Fiscal Strategy for Ireland," The Economic and Social Review, Economic and Social Studies, vol. 40(2), pages 233–253. [Downloadable!]
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