Revisiting Fiscal Shocks in the Open Economy

Despite extensive research on fiscal policy effects in recent times, comprehensive studies on the international transmission of structural fiscal shocks remains limited and inconclusive. We address these shortcomings in three key ways. First, we confront the perfect foresight problem associated to anticipated fiscal shocks by incorporating a proxy for fiscal policy news into a detailed multi-country model. This is the first study to use such a proxy to empirically determine the cross-border transmission of US fiscal shocks in such a detailed setting. Second, we use a Bayesian multi-country VAR, which, unlike existing two-country model studies, fully accounts for higher-order spillover effects. Third, with this setup, our empirical results reassess the interpretation of fiscal multipliers from New-Keynesian closed-economy models. Key findings include: i) international spillovers mainly operate through trade channels (expenditure switching and boosting); ii) the transmission mechanism hinges on the recipient country’s underlying ‘growth model; and iii) higher-order spillover effects markedly amplify direct spillover effects; and iv) the exchange rate puzzle is rather an artifact of an omitted variable problem and of the policy regime.