Working Paper: CEPR ID: DP6092
Authors: Carlo A. Favero; Francesco Giavazzi
Abstract: A shift in taxes or in government spending (a ?fiscal shock?) at some point in time puts a constraint on the path of taxes and spending in the future, since the government 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 arises 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 omitting a debt feedback can result in incorrect estimates of the dynamic effects of fiscal shocks. In particular, the absence of an effect of fiscal shocks on long-term interest rates?a frequent finding in studies that omit a debt feedback?can be explained by their mis-specification. Using data for the U.S. economy and two alternative identification assumptions we reconsider the effects of fiscal policy shocks correcting for these shortcomings.
Keywords: Fiscal Policy; Government Budget Constraint; Public Debt; VAR Models
JEL Codes: E62; H60
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Omitting debt dynamics (E19) | incorrect estimates of fiscal shocks' effects (H31) |
| Fiscal shock occurs (E62) | government adjusts taxes and spending (H59) |
| government adjusts taxes and spending (H59) | impacts macroeconomic variables over time (F41) |
| Absence of feedback mechanism from debt levels (F65) | biased impulse responses (E71) |
| Fiscal authorities' behavior has changed over time (H30) | differing responses of interest rates and inflation to fiscal shocks (E62) |
| Fiscal policy reaction function has become stabilizing post-1980 (E63) | contrasts with pre-1980 behavior (P17) |
| Including debt dynamics (H63) | larger impacts on output and interest rates from fiscal shocks (E62) |