Working Paper: CEPR ID: DP1284
Authors: Francesco Giavazzi; Marco Pagano
Abstract: In earlier work we documented two episodes in which a sharp fiscal consolidation was associated with a surprisingly large expansion in private domestic demand. In this paper we draw on further evidence to investigate if and when fiscal policy changes can have such non-Keynesian effects. In the first part of the paper, we analyse cross-country data for 19 OECD countries. In the second part we concentrate on the Swedish fiscal expansion of the early 1990s. The cross-country evidence on private consumption confirms that fiscal policy changes - both contractions and expansions - can have non-Keynesian effects if they are sufficiently large and persistent. It also suggests that these effects can result not only from changes in public consumption, but to some extent also from changes in taxes and transfers. The latter result is also consistent with the Swedish experience, where a decrease in net taxes (with almost no change in public consumption) was associated with a dramatic fall in private domestic demand. Our evidence and that from other studies agree that during the Swedish fiscal expansion of the early 1990s a large negative error should be interpreted, but it is clear that the most obvious candidates (wealth effects and after-tax real interest rate effects) are not sufficient to explain it. This error may reflect a large downward revision of permanent disposable income, which affected the consumption choices of Swedish households over and beyond the negative effects of the drop in real asset prices. We suggest that this downward revision in permanent disposable income may have been triggered, at least partly, by the fiscal expansion of the early 1990s.
Keywords: fiscal policy; stabilization; public debt; public deficit; public consumption; private consumption; private investment
JEL Codes: E21; E22; E62; E63; E65
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fiscal policy changes (decrease in net taxes) (H39) | Private consumption (fall in private domestic demand) (D12) |
| Fiscal policy changes (large and persistent) (E62) | Nonkeynesian effects on private consumption (E21) |
| Downward revision of permanent disposable income (E31) | Consumption choices (D10) |
| Large negative shock (E32) | Consumption and investment in Sweden (E20) |