Working Paper: NBER ID: w12822
Authors: Carlo 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: No keywords provided
JEL Codes: E62; H60
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fiscal shocks (H39) | Future path of public debt (H68) |
| Level of debt (F34) | Estimates of effects of fiscal shocks (H31) |
| Fiscal shocks (H39) | Long-term interest rates (E43) |
| Traditional VAR models (C32) | Biased impulse response estimates (C51) |
| Fiscal policy responses (E62) | Debt-to-GDP ratio stabilization (H63) |
| Fiscal policy (E62) | Consumption (E21) |
| Fiscal policy (E62) | Output (Y10) |