How would a fiscal shock in Germany affect other European countries? Evidence from a Bayesian GVAR model with sign restrictions

In this paper we analyze the international effects of a fiscal policy shock in Germany on other European countries. To that end we use a flexible version of a Bayesian global vector autoregression (GVAR) model and a dataset with broad country coverage comprising a wide range of macroeconomic and financial variables. Our results suggest a comparatively strong response in a majority of European economies to such a shock. In particular, we provide evidence that a deficit-financed expansionary government spending shock in Germany generates long-lasting positive cross-border output spillovers. In the case of the euro area periphery and Central, Eastern and Southeastern (CESEE) economies, these effects may be transmitted via the financial channel since financial variables such as equity prices and private sector credit significantly increase in response to the assumed fiscal shock in Germany. Upward effects on consumer prices, by contrast, are limited to core euro area countries. When looking at the effects of an expansionary tax cut shock instead of those of a spending-driven fiscal shock, we identify cross-border output spillovers of a similar magnitude but with a lower degree of persistence; in the case of CESEE economies, these results are also characterized by more estimation uncertainty. Finally, we also provide evidence for considerable cross-country heterogeneity in fiscal spillovers; for instance within CESEE, output responses to a fiscal shock in Germany are strongest in Croatia, Hungary and Slovenia.