Working Paper: CEPR ID: DP7535
Authors: Giancarlo Corsetti; Andr Meier; Gernot Müller
Abstract: The global recession of 2008-09 has revived interest in the international repercussions of domestic policy choices. This paper focuses on the case of fiscal stimulus, investigating cross-border spillovers from an increase in exhaustive government spending on the basis of a two-country business cycle model. Our model allows spillovers to be affected by a range of features, including trade elasticities, the size and openness of economies, as well as financial imperfections. Beyond these well-known determinants, however, we highlight the central importance of policy frameworks, notably the medium-term debt consolidation regime. We consider the plausible case in which a temporary debt-financed increase in government spending gives rise to higher future taxes along with some reduction in spending over time. The anticipated spending reversal not only strengthens the domestic stimulus effect but also enhances positive cross-border spillovers through its impact on global long-term interest rates. Thus, our findings lend support to the notion that coordinated short-term stimulus policies are most effective when coupled with credible medium-term consolidation plans featuring at least some spending restraint.
Keywords: debt consolidation; fiscal policy; international spillovers; monetary policy
JEL Codes: E62; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Exogenous increase in government spending (E62) | Expansion of output (C67) |
| Exogenous increase in government spending (E62) | Contraction in private consumption (E20) |
| Expansion of output (C67) | Increase in foreign demand (F29) |
| Rising global interest rates (E43) | Counteraction of positive effect on foreign demand (F69) |
| Initial increase in government spending (E62) | Subsequent spending reduction (H69) |
| Subsequent spending reduction (H69) | Strengthening of domestic stimulus effects (H31) |
| Strengthening of domestic stimulus effects (H31) | Enhancement of positive spillovers internationally (F69) |
| Spending reversals (E62) | Significant positive spillovers in foreign output (F69) |
| Coordinated short-term stimulus policies + Credible medium-term consolidation plans (E61) | Most effective stimulus effects (E65) |
| Fiscal expansions (E62) | Real exchange rates may depreciate (F31) |