Lecture 6 Slides The Effects of Fiscal Changes - Fiscal

LECTURE 6 The Effects of Fiscal Changes:

Fiscal Consolidations

September 28, 2016

Economics 210c/236a Christina Romer Fall 2016 David Romer

I. OVERVIEW OF THE IMPACT OF FISCAL CONSOLIDATIONS

How could fiscal contractions be expansionary?

• Wealth effect: With Ricardian consumers, a decrease in G makes people expect lower future taxes. As a result, wealth rises, consumption rises, and labor supply falls. Effects on Y could be positive if prices are sticky.

• Confidence effect: If budget problems are severe, dealing with them may prevent having to take more extreme measures later on. Thus, consolidation can have positive confidence effects on C and I.

How could fiscal contractions be expansionary? (continued)

• Interest rate effect: Fiscal consolidations may lower risk premium and so lower long rates. This may raise both I and C.

• Coincidence: Budget problems are a symptom of dysfunctional government. Fiscal consolidation is a sign that the government is functioning, and so may be correlated with other measures that are good for growth (i.e. relationship could be present but not causal).

II. GIAVAZZI AND PAGANO: “CAN SEVERE FISCAL CONTRACTIONS BE EXPANSIONARY? TALES OF TWO

SMALL EUROPEAN COUNTRIES”

Giavazzi and Pagano’s Regression

Possible Omitted Variable Bias

• Cyclical adjustment may not fully deal with cyclicality of revenues.

• Countercyclical discretionary policy.

• Other policies (like labor market and trade) may be correlated with fiscal reforms.

From: Giavazzi and Pagano, “Can Severe Fiscal Contractions be Expansionary?”

From: Giavazzi and Pagano, “Can Severe Fiscal Contractions be Expansionary?”

Research Strategy

• Look at Denmark in early 1980s and Ireland in late 1980s.

• Is this a sensible research strategy?

• What might be a more sensible strategy?

• What are they trying to learn from these case studies?

From: Giavazzi and Pagano, “Can Severe Fiscal Contractions be Expansionary?”

From: Giavazzi and Pagano, “Can Severe Fiscal Contractions be Expansionary?”

From: Giavazzi and Pagano, “Can Severe Fiscal Contractions be Expansionary?”

Alesina and Ardagna’s Measure of Fiscal Consolidations

• A year when the cyclically adjusted primary balance (CAPB) improves by at least 1.5% of GDP.

• Primary balance is the budget position net of interest payments.

• Cyclically-adjust the budget data using simple regression against the unemployment rate. (CBO and OECD uses more detailed methods.)

From: Alesina and Ardagna, “Large Changes in Fiscal Policy: Taxes Versus Spending”

III. GUAJARDO, LEIGH, AND PESCATORI: “EXPANSIONARY AUSTERITY: INTERNATIONAL EVIDENCE”

Possible Problems with the Conventional CAPB Indicator of Fiscal Consolidations

• Something like a stock market boom may raise CAPB and be correlated with other factors raising output.

• Discretionary changes in CAPB may be taken in response to the state of the economy.

• One-time accounting changes may lead to attenuation bias.

Narrative Approach

• Based on real-time OECD, IMF, and country budget reports and documents.

• 17 countries for 1978–2009.

• Try to determine when there were deliberate fiscal consolidations and whether they were taken in response to the economy.

• Use ex ante estimates of size of actions.

Evaluation of the Narrative Measure

From: Guajardo, Leigh, and Pescatori, “Expansionary Austerity”

Some Examples of Large Differences between the Two Measures

• Germany (1995 and 1996)

• Ireland (2009)

• Denmark (1986)

• Italy (1993)

From: Guajardo, Leigh, and Pescatori, “Expansionary Austerity”

• Is this test sensible?

Single-Equation Specification

• Where Yi,t is an outcome in country i in year t and F is the change in CAPB ratio.

• k is set equal to 2 (using annual data).

• Run using both OLS and instrumenting with their narrative measure of fiscal consolidations.

• Would it be more sensible to enter narrative measure directly?

From: Guajardo, Leigh, and Pescatori, “Expansionary Austerity”

VAR Specification

• 4 variables (in this order):

• Narrative measure of consolidation shocks.

• Change in CAPB ratio

• Change in log consumption

• Change in log GDP

• 2 lags

• Consider an impulse to equation 1 (narrative measure) such that it results in a contemporaneous rise in CAPB ratio of 1% of GDP.

For Comparison with CAPB Measure

• Same VAR (in same order):

• Change in CAPB ratio is second equation

• Consider an impulse to equation 2 (change in CAPB ratio) of 1% of GDP.

• Is this sensible? What observations are they using to estimate the IRF to a change in CAPB ratio?

From: Guajardo, Leigh, and Pescatori, “Expansionary Austerity”

From: Guajardo, Leigh, and Pescatori, “Expansionary Austerity”

Calculating a Fiscal Multiplier from a VAR

• Over some horizon, take the cumulative percentage change in GDP and the cumulative change in the fiscal variable (as a percent of GDP) in response to impulse (either in itself or in the instrument).

• Calculate the ratio. In this case −1.57/1.68 = 0.93.

Extension: Splitting Narrative Measure into Spending-Based and Tax-Based Consolidations

• How do they do it?

• Is this sensible?

• Run a 5-variable VAR

• GLP don’t tell us timing/ordering assumption; might it matter?

From: IMF, “Will it Hurt? Macroeconomic Effects of Fiscal Consolidation”

From: Guajardo, Leigh, and Pescatori, “Expansionary Austerity”

Figure 9 VARs for the Two Types of Exogenous Tax Changes and Real GDP

From: Romer and Romer, “ A New Measure of Fiscal Shocks”

-5.0

-3.0

-1.0

1.0

3.0

5.0

7.0

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Per

cent

Quarter

d. Response of GDP to Tax

Using Deficit-Driven Tax Changes

Extension: Role of Monetary Policy in Explaining Different Results with Spending-Based and

Tax-Based Consolidations

• Add the change in the policy interest rate to the VAR.

• Order it last.

From: Guajardo, Leigh, and Pescatori, “Expansionary Austerity”

From: IMF, “Will it Hurt? Macroeconomic Effects of Fiscal Consolidation”

Extension: Splitting Narrative Measure into High and Low-Sovereign Default Episodes

• How do they do it?

• Is this sensible?

• Run a 5-variable VAR

• What would be an obvious alternative approach?

From: Guajardo, Leigh, and Pescatori, “Expansionary Austerity”

IV. ALESINA, FAVERO, AND GIAVAZZI: “THE OUTPUT EFFECT OF FISCAL CONSOLIDATION PLANS”

A, F, and G’s Focus

• Interested in fiscal plans – multiyear programs of fiscal consolidation.

• Follow WEO’s narrative identification of fiscal consolidations.

• Interested in effects of tax increases versus spending cuts.

Notation • τ means tax increases, g means government spending

cuts.

• e = τ + g.

• Superscripts: u means unanticipated (announced in t, implemented in t). a means anticipated (announced at least a year before being implemented).

• Subscripts: i countries, t years, j years in advance.

• Example: eai,t,j (j > 0) is consolidation in country i

announced in (by?) year t to be implemented in year t + j.

A Couple of Their Equations

•

•

Notation (continued)

• TB means tax-based, EB means expenditure-based:

• Why 0-1 rather than continuous?

Specification

Restrictions That Are Imposed

• Only the ϕ’s vary by country.

• The ϕ’s are the same for tax-based and expenditure-based consolidations.

• The impact of anticipated changes does not depend on how long they have been anticipated for.

• The impact of anticipated changes when they are implemented interacts with the current EB-TB dummies.

Results

Implications for Selected Countries

Some Issues

• Why are the estimates so similar across countries?

• Why are the standard errors so small?

Why Are the Standard Errors So Small?

From: Guajardo et al. (1.65-s.e. confidence intervals); Alesina et al. (1-s.e.)

Why Are the Standard Errors So Small? (continued)

Additional Issues

• Does monetary policy explain the differences in the effects of tax-based and expenditure-based plans?

• Final thoughts.

V. BLANCHARD AND LEIGH: “GROWTH FORECAST ERRORS AND FISCAL MULTIPLIERS”

Blanchard and Leigh’s Basic Equation

Where:

• ΔYi,t:t+1 is real GDP growth in country i from 2010 to 2011.

• ΔYi,t:t+1|t is the forecast of that GDP growth made in April 2010.

• ΔFi,t:t+1|t is the forecast of the change in the cyclically-adjusted budget surplus in 2010-11 as a percent of potential GDP made in April 2010.

Blanchard and Leigh’s Basic Results

Robustness

Considering Different Time Periods