The Growth

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The growth of governmentspending and the money supply

Evidence and implications within and acrossindustrial countries

Magda Kandil International Monetary Fund, Washington, District of Columbia, USA

Abstract

Purpose – Using quarterly data for a sample of 17 industrial countries, the purpose of this paper is tostudy asymmetry in the face of monetary shocks compared to government spending shocks.

Design/methodology/approach – The paper outlines demand and supply channels determining the

asymmetric effects of monetary and fiscal policies. The time-series model is presented and an analysis of the difference in the asymmetric effects of monetary and fiscal shocks within countries is presented.There then follows an investigation of the relevance of demand and supply conditionsto the asymmetriceffects of monetary and fiscal shocks. The implications of asymmetry are contrasted across countries.

Findings – Fluctuations in real output growth, price inflation, wage inflation, and real wage growthvary with respect to anticipated and unanticipated shifts to the money supply, government spending,and the energy price. The asymmetric flexibility of prices appears a major factor in differentiating theexpansionary and contractionary effects of fiscal and monetary shocks. Higher price inflation, relativeto deflation, exacerbates output contraction, relative to expansion, in the face of monetary shocks. Incontrast, larger price deflation, relative to inflation, moderates output contraction, relative toexpansion in the face of government spending shocks. The growth of output and the real wagedecreases, on average, in the face of monetary variability in many countries. Moreover, the growth of real output and the real wage increases, on average, in the face of government spending variability inmany countries. Asymmetry differentiates the effects of monetary and government spending shocks

within and across countries. The degree and direction of asymmetry provide a new dimension todifferentiate between monetary and fiscal tools in the design of stabilization policies.

Originality/value – The paper’s evidence sheds light on the validity of theoretical modelsexplaining asymmetry in the effects of demand-side stabilization policies. Moreover, the evidenceshould alert policy makers to the need to relax structural and institutional constraints to maximize thebenefits of stabilization policies and minimize the adverse effects on economic variables.

Keywords Monetary policy, Fiscal policy, Government policy, Industrialized economies, Inflation,Deflation

Paper type Research paper

1. Introduction

In recent years there has been a lot of discussion about the role of stabilization policies.During a recession, it is possible to stimulate the economy through expansionary fiscalor monetary policies. The increased demand is likely, in turn, to stimulate outputgrowth and price inflation. Conversely, during a boom it is possible to curb excessdemand through contractionary fiscal or monetary policies. Demand reduction islikely, in turn, to moderate output growth and price inflation.

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/0144-3585.htm

The views expressed in the paper are those of the author and should not be interpreted as thoseof the International Monetary Fund.

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Vol. 33 No. 6, 2006

pp. 406-436

q Emerald Group Publishing Limited

0144-3585

DOI 10.1108/01443580610710398

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The stabilizing function of monetary and fiscal policies is dependent on their effectson nominal and real variables[1]. Demand and/or supply conditions may differentiatethe expansionary and contractionary effects of monetary and fiscal policies. On thedemand side, the size of aggregate demand shifts may be different with respect to

positive and negative shocks to government spending and the money supply.Assuming symmetric size demand shifts, however, the shape of the aggregate supplycurve may differentiate the effects of positive and negative policy shocks on each of real output growth and price inflation. For example, assuming a steeper supply curvein the face of positive shocks, price inflation is larger compared to price deflation.Consistently, output contraction exceeds expansion in the face of symmetric policyshocks. The degree and direction of asymmetry may provide a new dimension todifferentiate between monetary and fiscal tools in the design of stabilization policies.

Aggregate demand shifts may be different in the face of expansionary andcontractionary government spending shocks. An increase in government spendingincreases the demand for goods and, therefore, total income. The increased spendingmay prompt the government to issue more bonds. If the public perceives governmentbonds as wealth, private consumption increases. Alternatively, if consumers areRicardian they are likely to discount fully future tax liabilities associated with theincreased government spending. Moreover, expansionary government spendingshocks increase the demand for loanable funds and raise the interest rate, crowding outprivate spending. The behavior of Ricardian consumers and conditions in the creditmarket may be different with respect to positive and negative government spendingshocks, generating demand-side asymmetry.

The size of aggregate demand shifts may also be different with respect to positiveand negative monetary shocks. Money supply contraction decreases credit availabilityand raises the interest rate. Higher interest rates increase the cost of borrowers’bankruptcy, prompting banks to change their lending behavior and begin to ration

credit. Lending behavior and credit constraints may differentiate the effects of monetary policy on private spending during expansions and contractions.

On the supply side, conditions in labor and/or product markets may differentiate theslope of the supply curve in the face of expansionary and contractionary demandshocks. If wages and/or prices are more flexible in the upward direction compared tothe downward direction, equal size demand shifts will have asymmetric effects on eachof output and price.

Given theoretical arguments for sources of demand and/or supply asymmetry,previous investigations (Kandil, 2001, 2002a) provided evidence of asymmetry in theeffects of monetary and government spending shocks using data for interest rates,output, prices, and wages in the USA. The present investigation will explore theevidence of asymmetry in the response of economic variables to monetary and

government spending shocks using quarterly data for a sample of 17 industrialcountries. Based on the empirical evidence, correlations across countries establish theimportance of supply-side conditions in differentiating the results of fiscal and monetarypolicies. Clearly, expansionary monetary shocks stimulate inflationary expectations.Hence, producers are more inclined to raise prices in the face of expansionary monetaryshocks. Price inflation is generally lower in the face of expansionary governmentspending shocks. Prices, in contrast, are rigid to adjust downward in the face of contractionary monetary shocks. Price deflation is, however, more pronounced in the

Governmentspending and the

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face of contractionary government spending shocks. The difference in nominal wageadjustment appears less pronounced in the face of government spending and monetaryshocks. Asymmetric price adjustment differentiates, however, the effects of fiscal andmonetary policies on real output growth. Specifically, downward price rigidity

exacerbates output contraction in the face of monetary shocks relative to governmentspending shocks.

The evidence of higher upward price flexibility relative to downward flexibilityindicates that monetary variability increases price inflation and decreases real wageand output growth, on average, in many countries. In contrast, the variability of government spending decreases price inflation and increases real wage and outputgrowth, on average, in many countries. Across countries, higher price inflationmoderates the growth of output and the real wage in the face of expansionarymonetary shocks. In contrast, the downward rigidity of price exacerbates the reductionof output and the real wage in the face of contractionary monetary shocks. Lower priceinflation, in contrast, stimulates higher growth of output and the real wage in the faceof expansionary government spending shocks. Further, the downward flexibility of

price moderates the reduction of output and the real wage in the face of contractionarygovernment spending shocks.

The remainder of the investigation is organized as follows. Section 2 outlinesdemand and supply channels determining the asymmetric effects of monetary andfiscal policies. Section 3 presents the time-series model. Section 4 analyzes thedifference in the asymmetric effects of monetary and fiscal shocks within countries.Section 5 investigates the relevance of demand and supply conditions to theasymmetric effects of monetary and fiscal shocks. The implications of asymmetry arethen contrasted across countries. A summary and conclusion are provided in Section 6.

2. Theoretical framework

This section illustrates determinants of asymmetry in the face of demand-stabilizingpolicies. Traditionally, these policies have included the management of the moneysupply and/or government spending. The former aims at varying the money supply todetermine the level of liquidity and, therefore, private spending. The latter aims atdetermining aggregate demand by varying the level of public spending.

Asymmetry in the face of monetary and fiscal policies can be generallydifferentiated into demand- and supply-side channels (Kandil, 1995, 1996, 1998, 1999;Karras, 1996a, b; Apergis and Miller, 2005). Consider the following relationship:

Dvt ¼X x

j¼0

b m pvjposmt 2 j þX x

j¼0

b mnvjnegmt 2 j

þX x

j¼0

b g pvj

pos g t 2 j þX x

j¼0

b g nvj

neg g t 2 j; v ¼ y; p; nw; rw

ð1Þ

D (.) is the first-difference operator. The log of real output is denoted by y where pdenotes the log value of the price level. The log value of the nominal and real wage isdenoted by nw and rw, respectively. Monetary shocks are differentiated into distributedlags of positive and negative shocks, posmt - j and negmt - j . The difference between b pvj

m

and b nvj m measures asymmetry in the variables’ response to monetary shocks.

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Government spending shocks are differentiated into distributed lags of positive and

negative shocks, pos g t - j and neg g t - j . The difference between b pvj g and b nvj

g measuresasymmetry in the variables’ response to government spending shocks. The b

parameters are likely to be determined by two factors:

(1) the size of aggregate demand shifts in the face of the policy shock; and

(2) conditions on the supply side that determine capacity constraints and priceflexibility in the face of aggregate demand shifts.

2.1 The asymmetric effects of policy shocksConditions on the demand and/or the supply side of the economy may differentiate

the expansionary and contractionary effects of shocks to government spending and themoney supply.

2.1.1 Demand-side asymmetry in the face of government spending shocks. The

traditional view is that an increase in government spending will stimulate aggregatedemand. The effects of government spending are likely, however, to be complicated by

two factors. First, binding liquidity constraints may differentiate the effects of government spending on financial markets. An increase in government spending islikely to increase the budget deficit[2]. To finance the increased spending, thegovernment increases borrowing. Given the limited supply of available loanable funds

above capacity level, an increase in government borrowing raises the interest rate,crowding out private spending. This channel moderates the expansionary effects of anincrease in government spending on aggregate demand. As government debt builds upwith fiscal expansion(s). Miller et al. (1990) argue that the mounting risk of default or

increasing inflation risk will reinforce crowding our effects through interest rates.Hence, policy credibility is crucial. That is, if the government lacks a track record of fiscal prudence, the interest rates will most likely reflect risk premia. Sizable risk

premia represent perhaps the clearest reason that fiscal multipliers could turn negative.

That is, private spending decreases in the face of a rise in the interest rate induced by asizable risk premia following a fiscal expansion[3]. If crowding out is larger in the faceof expansionary government spending shocks, the size of aggregate demand shifts will

differentiate the effects of expansionary and contractionary shocks on product andlabor markets.

In another direction, some economists have questioned the importance of changes inthe interest rate in response to government spending. They appeal to the Ricardian

equivalence argument to emphasize the importance of government spending on privatesavings[4]. Given concerns about the budget deficit, agents foresee future tax liabilitiesassociated with the increased government spending. Accordingly, privateconsumption is likely to decrease in response to the increased government spending.

The reduction in private consumption moderates demand expansion. Risk aversehouseholds are likely to assign high probability to future tax liability[5]. If consumersare more Ricardian in the face of expansionary government spending shocks, the size

of aggregate demand shifts will differentiate the effects of expansionary andcontractionary shocks in product and labor markets.

2.1.2 Demand-side asymmetry in the face of monetary shocks. Theoretical channelsmay differentiate demand shifts in response to expansionary and contractionarymonetary shocks as follows:


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. Money supply contraction decreases credit availability and raises the interestrate. Higher interest rates increase the cost of borrowing, decreasing privatespending. Higher interest rates increase the risk of borrowers’ bankruptcy,prompting banks to change their lending behavior, and begin to ration credit.

This credit constraint further suppresses private spending and augments thecentral bank’s tight policy[6].

. Expansionary monetary policy, in contrast, is negatively influenced by creditconstraints. Money supply expansion increases the availability of credit anddecreases the interest rate. A reduction in interest rates will not lead, however, tohigher levels of borrowing and spending. This is because banks’ willingness tolend may not stimulate an increase in spending without an increase in thedemand for credit[7].

2.2 Supply-side asymmetryConditions on the supply side in the labor and/or product markets may differentiate the

slope of the aggregate supply curve in the face of expansionary and contractionaryaggregate demand shifts. New Keynesian explanations have focused on marketimperfections towards an explanation of asymmetric fluctuations. The source of rigidity has varied between sticky-wage and sticky-price explanations.

Sticky-wage models have traced sources of cyclical fluctuations to conditions in thelabor market[8]. Implicit or explicit labor contracts may offer an explanation. Givennominal wage rigidity, an unanticipated increase in price, in response, e.g. to a positiveshock to government spending or the money supply, decreases the real wage andincreases the output supplied in the short-run. Conditions in the labor market maydifferentiate, however, upward and downward nominal wage flexibility in the face of expansionary and contractionary demand shocks[9]. In a scenario that assumes moreflexibility of the nominal wage in the upward direction, positive demand shocks willprompt instantaneous rise of wages. The upward flexibility of the nominal wagemoderates the reduction of the real wage and the increase in output growth in the faceof expansionary demand shocks. Consequently, the increased demand will be reflectedin a higher cost of the output produced and, in turn, higher prices. In contrast, if nominal wages are more downwardly rigid, the counter cyclical response (increase) of the real wage exacerbates the contractionary effect of negative demand shocks onoutput and moderates the deflationary effect on prices. Accordingly, asymmetricnominal wage adjustment implies a steeper supply curve in the face of expansionarydemand shifts compared to contractionary shifts.

Sticky-price explanations have isolated output fluctuations in the short-run fromconditions in the labor market[10]. Menu costs limit the frequency of adjusting prices

over time. These are the costs involved in implementing and announcing a pricechange. Given price rigidity, firms resort to adjusting output in the short-run inresponse to unanticipated demand shifts, e.g. a positive shock to government spendingor the money supply. Conditions in the product market may establish, however, thatprices adjust asymmetrically in the face of demand shocks[11]. Asymmetric priceadjustment implies that shifts in aggregate demand have asymmetric effects on output.Since, prices are sticky downward, a fall in aggregate demand reduces output. Higherupward flexibility of prices moderates the rise in output in response to expansionary

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demand shocks. Accordingly, asymmetric price adjustment implies a steeper supplycurve in the face of expansionary demand shifts compared to contractionary shifts.

3. Empirical modelsEconomies are impinged on by many different shocks: some short-run, some long-run,some supply-side, some demand-side shocks, some temporary, and some permanentshocks. The empirical model accounts for two types of demand-side shifts: monetaryand fiscal shifts. Supply-side shifts are approximated by changes in the energy price.Each of the demand and supply-side shifts is decomposed into anticipated (permanent)and unanticipated (temporary) components. Anticipated demand shifts varyendogenously with domestic and external variables that guide agents’ forecasts of macroeconomic fundamentals.

Conditions on the demand and/or supply sides may determine the asymmetriceffects of monetary and government spending shocks on variables in labor and productmarkets. To investigate these effects, empirical models are specified to replicate thereduced-form solutions of output, price, the nominal wage, and the real wage intheory[12].

The specification of empirical models assumes a production function in which laborand energy are complements. Accordingly, variables in labor and product marketsfluctuate in response to aggregate demand and energy price shifts. Assuming rationalexpectations, demand and supply shifts impinging on the economic system can bedivided into anticipated and unanticipated components. Nominal variables in laborand product markets adjust in anticipation of demand shifts, neutralizing their effectson real output[13]. Unanticipated demand shifts, in contrast, determine real output witha magnitude that is dependent on the degree of nominal wage and/or price rigidity.Supply shifts, both anticipated and unanticipated, enter the production functiondetermining nominal and real variables in labor and product markets. Fluctuations in

nominal and real variables in response to demand and supply shifts are approximated,therefore, as follows[14]:

Dpt ¼ a0 þ a1 E t 21 Dqt þ a2 E t 21 Dg t þ a3 E t 21 Dmt

þXl

j¼0

a pgjpos g t 2 j þXl

j¼0

angjneg g t 2 j þXl

j¼0

a pmjposmt 2 j

þXl

j¼0

anmjnegmt 2 j þXl

j¼0

a4 j Dqst 2 j þ h pt

ð2Þ

Dnwt ¼ b0 þ b1 E t 21 Dqt þ b2 E t 21 Dg t þ b3 E t 21 Dmt

þXl

j¼0

b pgjpos g t 2 j þXl

j¼0

bngjneg g t 2 j þXl

j¼0

b pmjposmt 2 j

þXl

j¼0

bnmjnegmt 2 j þXl

j¼0

b4 j Dqst 2 j þ h nwt

ð3Þ


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Drwt ¼ c0 þ c1 E t 21 Dqt þ c2 E t 21 Dg t þ c3 E t 21 Dmt

þ

Xl

j¼0

c pgjpos g t 2 j þ

Xl

j¼0

cngjneg g t 2 j þ

Xl

j¼0

c pmjposmt 2 j

þXl

j¼0

cnmjnegmt 2 j þXl

j¼0

c4 j Dqst 2 j þ h rwt

ð4Þ

Dyt ¼ d 0 þ d 1 E t 21 Dqt þ d 2 Dyt 21 þXl

j¼0

d pgjpos g t 2 j þXl

j¼0

d ngjneg g t 2 j

þXl

j¼0

d pmjposmt 2 j þXl

j¼0

d nmjnegmt 2 j þXl

j¼0

d 4 j Dqst 2 j þ h yt

ð5Þ

The log value of the price level, the nominal wage, the real wage, and real output aredenoted pt , nwt , rwt , and yt , respectively. Stationarity is tested following thesuggestions of Nelson and Plosser (1982). The results of the augmented Dickey-Fullertest (Dickey and Fuller, 1981), reject stationarity of variables under investigation.Given these results, the empirical models are specified in first-difference form where D (.) is the first-difference operator[15]. The terms h pt , h nwt , h rwt , and h yt are randomunexplained residuals with a zero mean and a constant variance.

Supply-side shifts are approximated by anticipated and unanticipated changes inthe energy price[16]. The log value of the energy price is denoted by qt . Anticipatedgrowth in the energy price given information at time t – 1 is denoted by E t 21 Dqt .To capture persistence in cyclical fluctuations over time, the empirical modelsinclude contemporaneous and lagged shocks. The distributed-lag variable, Dqst - j ,

measures unanticipated change in the log value of the energy price given forecasts attime t – j – 1 where l denotes the lag length.

In addition to supply-side shifts, variables in labor and product markets fluctuate inresponse to demand-side shifts, as approximated by the growth of governmentspending and the money supply. Demand-side policy variables are allocated betweenreal and nominal variables in labor and product markets. Government spendingapproximates the discretionary component of fiscal policy that does not varyautomatically with cyclical fluctuations[17]. Shocks to government spending andthe money supply maybe endogenous to fluctuations in velocity, money demand, theinterest rate, or the exchange rate[18]. These endogenous fluctuations are part of thetransmission mechanism of policy shocks to labor and product markets. Accordingly,the forecast equations (see Appendix A for details) account for a variety of domestic

and external variables that may determine the direction of monetary and fiscal policies.Further, the growth of government spending and the money supply are likely to becorrelated. For example, if the Central Bank engages in the process of monetizing thebudget deficit, monetary growth accommodates the growth of government spending.Accordingly, the empirical models account for the growth of government spending andthe money supply to approximate demand-side shocks. Experiments that exclude oneof these shocks are consistent with the paper’s qualitative results. Details are availableupon request.

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Let g t be the log value of government spending[19]. Anticipated growth ingovernment spending given information at time t – 1 is denoted by E t 21 Dg t . Thiscomponent measures steady-state trend growth of government spending over time.Let mt be the log value of the money supply[20]. Anticipated steady-state trend

growth of the money supply given information at time t – 1 is denoted by E t 21 Dmt [21]. The effects of anticipated growth measure the permanent effects of changes in government spending and the money supply on economic variables[22].

Producers are likely to adjust prices to reflect anticipated rise in the energy price, i.e.a1 . 0. The rise in the cost of living prompts workers to negotiate higher nominalwages, i.e. b1 . 0[23]. Accordingly, the real wage response to anticipated rise in theenergy price is likely to depend on the relative adjustment of the nominal wage andprice, i.e. c1 $ 0. Anticipated higher cost of the energy input prompts producers toshrink the output supplied, i.e. d 1 , 0.

Energy price shocks are inflationary, increasing the output price and the nominalwage. That is,

P x j¼0a4 j . 0 and

P x j¼0b4 j . 0: The cumulative effect of energy price

shocks on the real wage is dependent on the relative inflationary effects on the nominal

wage and price. That is,P

x j¼0c4 j $ 0: The contractionary effect of an unanticipated

rise in the energy price on output is consistent withP x

j¼0d 4 j , 0:Anticipated demand shifts are likely to be absorbed in price and the nominal wage.

That is, a2, a3, b2, and b3 are positive. The relative effects on the nominal wage andprice determine the response of the real wage to anticipated demand shifts. That is, c2,c3 $ 0. The lagged dependent variable in equation (5) captures persistence in outputadjustment over time. Accordingly, d 2 . 0[24].

Shocks to government spending and the money supply are assumed to besymmetrically distributed around an anticipated stochastic trend that varies with agents’forecast. This trend corresponds to the steady state value which varies with agents’forecast of macroeconomic fundamentals (see Appendix 1 for details). Given thesymmetric distribution, the empirical model detects asymmetry in the adjustment of dependent variables to a given size demand shock, positive or negative. The cumulativeresponse of variables to the shocks to government spending and the money supply arelikely to vary with two factors:

(1) the size of aggregate demand shifts; and

(2) conditions on the supply-side.

Positive significant effects will indicate flexibility in demand and supply adjustmentsto policy shocks. Negative significant effects would indicate constraints on the demandand/or supply sides in the face of policy shocks. Insignificant effects indicate that thepositive and negative channels cancel out in the face of policy shocks. Evidence of asymmetry in models (2) through (5) will capture the combined effects of demand and

supply conditions in differentiating the expansionary and contractionary results of fiscal and monetary policies.

4. Empirical resultsThe empirical models (2) through (5) are estimated jointly using quarterly data for asample of 17 industrial countries over the sample period 1961.I-2001.IV. Detailedeconometric methodology is provided in Appendix 1. Description and sources of dataare provided in Appendix 2. The models are estimated for the lag length l ¼ 4, 6, 8.


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The results are reported for l ¼ 6[25]. To conserve space, Tables I-IV summarize thecumulative responses of variables to expansionary and contractionary demandshocks[26].

4.1 The relative inflationary effects of policy shocks on priceIn the price equation (2), estimates of the cumulative effects of policy shocks duringexpansions and contractions provide evidence of their relative inflationary effects.These estimates are summarized in Table I. Positive and statistically significantcumulative effects of expansionary shocks indicate an increase in price inflation.In contrast, a negative cumulative response to expansionary shocks indicates upwardrigidity, i.e. price inflation is decreasing despite expansionary policy shocks[27].Similarly, positive and statistically significant cumulative effects of contractionaryshocks indicate a decrease in price inflation. In contrast, a negative cumulativeresponse to contractionary shocks indicates downward rigidity, i.e. price inflation isincreasing despite contractionary policy shocks[28].

The difference between the cumulative effects of expansionary government

spending and monetary shocks (column (3) of Table I) formalizes their relativeinflationary effects on price. Apparently, higher flexibility of price in the face of expansionary monetary shocks compared to government spending shocks is morepervasive across countries. The difference between the cumulative effects of contractionary monetary and government spending shocks (column (6) of Table I)formalizes their relative deflationary effect on price. Apparently, price flexibility ismore evident in the face of contractionary government spending shocks compared tomonetary shocks across countries.

A statistically significant difference between the cumulative effects duringexpansions and contractions (Table I) formalizes asymmetric price flexibility in theface of government spending and monetary shocks. In column (7), price inflationexceeds deflation in the face of government spending shocks in Germany. Pricesappear more flexible (less rigid) in the face of contractionary compared to expansionarygovernment spending shocks in Belgium, Finland, France, Ireland, Norway, and theUSA[29]. In contrast, prices appear more flexible (less rigid) in the face of expansionarycompared to contractionary monetary shocks in Australia, Austria, Canada, Finland,The Netherlands, Norway, Sweden, the UK, and the USA. Price deflation exceedsinflation in the face of monetary shocks in Denmark, Italy, and Spain.

Given asymmetry, the variability of policy shocks differentiates the relative effectson price inflation during expansions and contractions. Based on cumulative effects, thecontribution of government spending shocks to average (steady-state) price inflationcan be approximated as follows:

E ð DpÞ g ¼ conpos g þ conneg g E ð DpÞ g ¼X6

j¼0a pgj E ðpos g Þ þ

X6

j¼0angj E ðneg g Þ ð6Þ

E (.) is the mathematical expectation operator. The subscript g denotes the componentof average price inflation that varies with government spending shocks. The termsconpos g and conneg g denote the contributions of positive and negative governmentspending shocks to average price inflation. The coefficients on the right-hand sidemeasure the cumulative response of price inflation to positive and negativegovernment spending shocks, as reported in Table I.

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C o u n t r y

( 1 ) d p g j

( 2 ) d p m j

( 3 ) ( d p g j –

d p m j )

( 4 ) d

n g j

( 5 ) d n m j

( 6 ) ( d n g j –

d n m j )

( 7

) ( d p g j –

d n g j )

( 8 ) ( d p m j –

d n m j )

( 9 ) E ( D y ) g

( 1 0 )

E ( D y ) m

( 1 1 )

E ( D y )

A u s t r a l i a

0 . 3

3 ( 0 . 8

4 )

0 . 1

9 ( 0 . 3

9 )

0 . 1

4 ( 0 . 3

6 )

2

0 . 0 8

( 2 0 . 2

2 )

2 . 3

2 * ( 4 . 0

6 )

2

2 . 4

0 * ( 2 6 . 3

0 )

0 . 4

1 ( 1 . 0

5 3 )

2

2 . 1

3 * ( 2 4 . 3

7 )

0 . 0

0 3 8

2

0 . 0

1 1

0 . 0

0 8 5

A u s t r i a

0 . 0

3 ( 0 . 0

8 )

2

0 . 1

4 ( 2 0 . 3

5 )

0 . 1

7 ( 0 . 4

7 )

2

0 . 2 5

( 2 0 . 5

0 )

0 . 4

7 * * ( 1 . 4

0 )

2

0 . 7

2 * * ( 2 1 . 4

4 )

0 . 2

8 ( 0 . 7

7 )

2

0 . 6

1 * * ( 2 1 . 5

3 )

0 . 0

0 5 1

2

0 . 0

0 5 8

0 . 0

1 1

B e l g i u m

2

0 . 2

8 ( 2 1 . 2 8 )

1 . 8

3 * ( 2 . 2

9 )

2

2 . 1

1 * ( 2 9 . 6

5 )

2

0 . 2 4

( 2 1 . 0

1 )

2

0 . 0

6 6 ( 2 0 . 1

1 )

2

0 . 1

7 ( 2 0 . 7

3 )

2

0 . 0

4 ( 2 0 . 1

8 )

1 . 9

0 * ( 2 . 3

7 )

2

0 . 0

0 2

0 . 0

1 6

0 . 0

0 6 3

C a n a d a

0 . 0

5 ( 0 . 1

9 )

0 . 0

3 4 ( 0 . 2

8 )

0 . 0

1 6 ( 0 . 0

6 )

0 . 0

3 7

( 0 . 0

9 2 )

0 . 1

4 ( 1 . 1

8 )

2

0 . 1

0 ( 2 0 . 2

6 )

0 . 0

1 3 ( 0 . 0

4 9 )

2

0 . 1

1 ( 2 0 . 8

7 )

0 . 0

0 0 0 9 2

0 . 0

0 7 4

0 . 0

1 0

D e n m a r k

0 . 5

1 ( 0 . 7

6 )

0 . 4

7 ( 1 . 0

1 4 )

0 . 0

4 ( 0 . 0

6 )

0 . 2 0

( 0 . 2

9 )

0 . 4

1 ( 0 . 4

9 )

2

0 . 2

1 ( 2 0 . 3

0 )

0 . 3

1 ( 0 . 4

6 )

0 . 0

6 ( 0 . 1

3 )

0 . 0

1 1

0 . 0

0 0 8

0 . 0

0 7 1

F i n l a n d

2

0 . 4

2 ( 2 1 . 1 8 )

0 . 0

7 6 ( 0 . 1

9 )

2

0 . 5

0 * * ( 2 1 . 4

0 )

2

1 . 0

1 *

( 2 2 . 2

3 )

0 . 5

2 ( 0 . 7

0 )

2

1 . 5

3 * ( 2 3 . 3

8 )

0 . 5

9 * * ( 1 . 6

6 )

2

0 . 4

4 ( 2 1 . 1

1 )

0 . 0

1 4

2

0 . 0

0 4 4

0 . 0

3 4

F r a n c e

0 . 0

2 ( 0 . 0

9 6 )

0 . 8

0 ( 0 . 8

7 )

2

0 . 7

8 * ( 2 3 . 7

4 )

0 . 1 9

( 0 . 8

0 )

0 . 1

6 ( 0 . 2

9 )

0 . 0

3 ( 0 . 1

3 )

2

0 . 1

7 ( 2 0 . 8

2 )

0 . 6

4 ( 0 . 7

0 )

2

0 . 0

1 2

0 . 0

0 3 6

0 . 0

0 8 4

G e r m a n y

0 . 0

4 5 ( 0 . 1

9 )

0 . 4

3 ( 0 . 7

4 )

2

0 . 3

9 * * ( 2 1 . 6

3 )

0 . 0

8 3

( 0 . 2

0 )

0 . 2

8 ( 0 . 4

3 )

2

0 . 2

0 ( 2 0 . 4

7 )

2

0 . 0

3 8 ( 2 0 . 1

6 )

0 . 1

5 ( 0 . 2

6 )

2

0 . 0

0 1 1

0 . 0

0 0 5

0 . 0

0 7 7

I r e l a n d

2

0 . 2

0 * * ( 2 1 . 5 8 )

0 . 2

3 ( 0 . 8

0 )

2

0 . 4

3 * ( 2 3 . 4

0 )

2

0 . 4

2 *

( 2 3 . 0

5 )

0 . 5

8 * * ( 1 . 6

8 )

2

1 . 0

0 * ( 2 7 . 2

6 )

0

. 2 2 * ( 1 . 7

4 )

2

0 . 3

5 ( 2 1 . 2

2 )

0 . 0

1 0

2

0 . 0

0 4 5

0 . 0

1 5

I t a l y

2

0 . 0

4 8 ( 2 0 . 4 5 )

2

0 . 0

3 8 ( 2 0 . 4

3 )

2

0 . 0

1 ( 2 0 . 0

9 4 )

2

0 . 0 5

( 2 0 . 4

8 )

0 . 1

4 ( 0 . 6

8 )

2

0 . 1

9 * ( 2 1 . 7

5 )

0 . 0

0 5 ( 0 . 0

4 7 )

2

0 . 1

8 * ( 2 2 . 0

1 4 )

0 . 0

0 0 3

2

0 . 0

0 5

0 . 0

0 9 8

J a p a n

0 . 1

4 ( 1 . 0

2 7 )

0 . 1

1 ( 0 . 5

4 )

0 . 0

3 ( 0 . 2

2 )

0 . 0

5 6

( 0 . 2

5 )

0 . 6

7 * ( 1 . 9

6 )

2

0 . 4

3 * ( 2 3 . 2

1 )

0 . 0

4 9 ( 0 . 3

6 )

2

0 . 4

1 * ( 2 2 . 0

1 2 )

0 . 0

0 0 7

2

0 . 0

0 4 1

0 . 0

1 6

T h e

N e t h e r l a n d s

0 . 1

2 ( 0 . 4

6 )

2

0 . 0

3 7 ( 2 0 . 0

9 4 )

0 . 1

6 ( 0 . 6

0 )

0 . 1 3

( 0 . 4

3 )

1 . 1

6 * ( 2 . 8

8 )

2

1 . 0

3 * ( 2 3 . 4

0 )

2

0 . 0

1 ( 2 0 . 0

3 8 )

2

1 . 2

0 * ( 2 3 . 0

4 )

2

0 . 0

0 0 4

2

0 . 0

1 2

0 . 0

0 9 8

N o r w a y

0 . 6

0 ( 0 . 6

0 )

2

1 . 8

4 * ( 2 1 . 9

8 )

2 . 4

4 * ( 2 . 4

4 )

2

0 . 4 0

( 2 0 . 2

4 )

0 . 6

6 ( 1 . 2

0 )

0 . 1

7 ( 0 . 1

2 )

0 . 3

5 ( 0 . 3

5 )

2

1 . 9

2 * ( 2 2 . 0

6 4 )

0 . 0

0 3 5

2

0 . 0

2 7

0 . 0

1 3

S p a i n

0 . 0

7 ( 0 . 3

6 )

2 . 3

2 * ( 3 . 9

3 )

2

2 . 2

5 * ( 2 1 1 . 5

7 )

2

0 . 2 5

( 2 0 . 5

2 )

2

1 . 0

9 ( 2 1 . 0

4 )

0 . 1

5 ( 0 . 9

4 )

0 . 2

7 * * ( 1 . 3

9 )

2 . 7

0 * ( 4 . 5

7 )

0 . 0

1 2

0 . 0

2 2

0 . 0

1 4

S w e d e n

2

0 . 2

6 * ( 2 1 . 6 9 )

0 . 2

5 * ( 2 . 7

6 )

2

0 . 5

1 * ( 2 3 . 3

2 )

2

0 . 4

1 *

( 2 2 . 2

8 )

0 . 2

3 ( 0 . 5

0 )

2

0 . 6

4 * ( 2 3 . 5

6 )

0 . 1

5 ( 0 . 9

8 )

0 . 0

2 ( 0 . 2

2 )

0 . 0

1 2

0 . 0

2 2

0 . 0

1 4

U K

2

0 . 2

7 ( 2 0 . 8 0 )

0 . 5

8 * ( 1 . 7

6 )

2

0 . 8

7 * ( 2 2 . 4

0 )

2

0 . 0 7

( 2 0 . 2

1 )

0 . 1

2 ( 0 . 4

4 )

2

0 . 1

9 ( 2 0 . 5

5 )

2

0 . 2

2 ( 2 0 . 6

0 )

0 . 4

6 * * ( 1 . 4

0 )

2

0 . 0

0 2 1

0 . 0

0 4

0 . 0

0 6 2

U S A

2

0 . 1

4 ( 2 0 . 3 8 )

2

0 . 3

4 ( 2 0 . 8

0 )

0 . 2

0 ( 0 . 5

4 )

0 . 0

7 9

( 0 . 1

6 )

0 . 7

2 * * ( 1 . 5

7 )

2

0 . 6

4 * * ( 2 1 . 3

1 )

2

0 . 2

2 ( 2 0 . 5

9 )

2

1 . 0

6 * ( 2 2 . 4

9 )

2

0 . 0

0 1 1

2

0 . 0

0 4 3

0 . 0

0 7 5

N o t e s : d p g j a n d d n g j m e a s u r e t h e c

u m u l a t i v e e f f e c t s o f e x p a n s i o n a r y a n d c o n t r a c t i o n a r y g o v e r n m e n t s p e n d i n g s h o c k s o n o u t p u t g r o w t h f o

r j ¼

0 , . .

.

, 6 i n m o d e l ( 7 ) ; d p m j a n d d n m j m e a s u r e t h e c u m u l a t i v e e f f e c t s

o f e x p a n s i o n a r y a n d c o n t r a c t i o n a

r y m o n e t a r y s h o c k s o n o u t p u t g r o w t h f o r j ¼

0 , . .

.

, 6 i n m o d e l ( 7 ) ; * a n d * * d e n o t e s t a t i s t i c a l s i g n i fi c

a n c e a t t h e fi v e a n d t e n p e r c e n t l e v e l s

Table IV.The relative effects of theshocks to governmentspending and the moneysupply on real outputgrowth

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Similarly, the contribution of monetary shocks to average price inflation can beapproximated as follows:

E ð DpÞm ¼ conposm þ connegm E ð DpÞm ¼X6

j¼0a pmj E ðposmÞ þ

X6

j¼0anmj E ðnegmÞ ð7Þ

The subscript m denotes the component of average price inflation that varies withmonetary shocks. The terms conposm and conneg m denote the contributions of positiveand negative monetary shocks to average price inflation. The coefficients on theright-hand side measure the cumulative response of price inflation to positive andnegative monetary shocks, as reported in Table I.

The procedure followed to calculate E (pos g ), E (neg g ), E (posm ), and E (negm ) isdescribed in Appendix A[30]. Table I summarizes the contributions of governmentspending shocks, E ( Dp ) g , and monetary shocks, E ( Dp )m, to average price inflation, E ( Dp ). Other factors are likely to contribute, however, to average price inflation,

positively or negatively. To indicate the significance of the reported contributions formonetary and government spending shocks, average price inflation is alsosummarized in Table I for various countries.

Consistent with the dominant deflationary effect of government spending shocks, thenet contribution of these shocks, in column (9), is negative, decreasing price inflation, onaverage, in the majority of countries (11 out of 17)[31]. In contrast, the positiveinflationary contribution of government spending shocks appears to be limited to a fewcountries[32]. Consistent with the dominant inflationary effect of monetary shocks, thenet contribution of these shocks is generally positive, in column (10), increasing priceinflation, on average, in the majority of countries (14 out of 17)[33]. The deflationarycontribution of monetary shocks is limited to three countries[34].

4.2 The relative inflationary effects of policy shocks on the nominal wageThe above evidence highlights pronounced differences in the asymmetric adjustmentof price inflation to government spending and monetary shocks. Are conditions in thelabor market relevant to this asymmetry? In the nominal wage equation (2), estimatesof the cumulative effects of policy shocks during expansions and contractions provideevidence of their relative inflationary effects. These estimates are summarized inTable II. Positive and statistically significant cumulative effects of expansionaryshocks indicate an increase in nominal wage inflation. In contrast, a negativecumulative response to expansionary shocks indicates nominal wage rigidity, i.e.nominal wage inflation is decreasing despite expansionary policy shocks. Similarly,positive and statistically significant cumulative effects of contractionary shocksindicate a decrease in nominal wage inflation. In contrast, a negative cumulative

response to contractionary shocks indicates downward rigidity, i.e. nominal wageinflation is increasing despite contractionary policy shocks.

The difference between the cumulative effects of expansionary governmentspending and monetary shocks formalizes their relative inflationary effects on thenominal wage. Clearly, the evidence concerning the inflationary effect of monetaryshocks is more widely spread for price compared to the nominal wage across countries.The difference between the cumulative effects of contractionary government spendingand monetary shocks formalizes their relative deflationary effects on the nominal


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wage. Clearly, the evidence concerning the deflationary effect of government spendingshocks is more widely spread for price compared to the nominal wage across countries.

A statistically significant difference between the cumulative effects duringexpansions and contractions (Table II) formalizes asymmetric nominal wage flexibility

in the face of government spending and monetary shocks. In column (7), nominalwages appear more flexible (less rigid) in the face of expansionary compared tocontractionary government spending shocks in Canada, Germany, and the UK.Nominal wages appear more flexible (less rigid) in the face of contractionary comparedto expansionary government spending shocks in France, and the United States.In column (8), nominal wage inflation exceeds deflation in the face of monetaryshocks in Australia and the United Kingdom. Nominal wages appear more flexible(less rigid) in the face of contractionary compared to expansionary monetary shocks inDenmark, Ireland, Italy, and Sweden. Asymmetry of nominal wage flexibility does notappear more pronounced in one direction in the face of monetary or governmentspending shocks in many countries.

Given asymmetry, the variability of policy shocks differentiates the relative effectson nominal wage inflation during expansions and contractions. Based on cumulativeeffects, Table II summarizes the contributions of government spending shocks, E ( Dnw ) g , and monetary shocks, E ( Dnw )m, to average nominal wage inflation, E ( Dnw ).In column (9), the net contribution of government spending shocks is negative,decreasing nominal wage inflation, on average, in seven countries[35]. In contrast, thenet contribution of government spending shocks is positive, increasing nominal wageinflation, on average, in the majority of countries (9 out of 17)[36]. In column (10), the netcontribution of monetary shocks is positive, increasing nominal wage inflation, onaverage, in eight countries[37]. In contrast, the net contribution of monetary shocks isnegative, decreasing nominal wage inflation, on average, in nine countries[38].

4.3 The relative effects of policy shocks on the real wageIn the real wage equation (4), estimates of the cumulative effects of policy shocksprovide evidence of their relative inflationary effects on the nominal wage and priceduring expansions and contractions. These estimates are summarized in Table III.Positive and statistically significant cumulative effects of expansionary shocksindicate an increase in real wage growth. In contrast, a negative cumulative responseindicates reduction in real wage growth in the face of expansionary policy shocks.Similarly, positive and statistically significant cumulative effects of contractionaryshocks indicate a reduction in real wage growth. In contrast, a negative cumulativeresponse to contractionary shocks indicates an increase in real wage growth despitecontractionary policy shocks.

The difference between the cumulative effects of expansionary monetary andgovernment spending shocks formalizes their relative effects on the real wage. Theevidence is consistent with higher price inflation in the face of monetary shocksrelative to government spending shocks in several countries. The difference betweenthe cumulative effects of contractionary monetary and government spending shocksformalizes their relative effects on the real wage. The evidence is consistent with thedownward flexibility of price which appears more prevalent in the face of contractionary government spending shocks in several countries.

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A statistically significant difference between the cumulative effects duringexpansions and contractions (Table III) formalizes asymmetric real wage flexibility inthe face of government spending and monetary shocks. In column (7), real wagegrowth exceeds reduction in the face of government spending shocks in Germany only.

Overall, statistical significance does not support asymmetry in the effects of government spending shocks on real wage growth during expansions andcontractions. In contrast, in column (8) the real wage reduction exceeds its growth inthe face of monetary shocks in Australia, Austria, Denmark, Ireland, Norway, Sweden,and the USA.

Given asymmetry, the variability of policy shocks differentiates the relative effectson real wage growth during expansions and contractions. Based on cumulative effects,Table III summarizes the contributions of government spending shocks, E ( Drw ) g , andmonetary shocks, E ( Drw )m, to average real wage growth, E ( Drw ). In column (9), the netcontribution of government spending shocks is positive, increasing real wage growth,on average, in the majority of countries (12 out of 17)[39]. The net contribution of government spending shocks is negative, decreasing real wage growth, on average, inFrance, Italy, Sweden, and the USA[40]. In column (10), the net contribution of monetary shocks is negative, decreasing real wage growth, on average, in the majorityof countries (13 out of 17)[41]. The net positive contribution of monetary shocks toaverage real wage growth is evident in four countries, Belgium, France, Spain, and theUK[42].

4.4 The relative effects of policy shocks on real output In the output equation (5), estimates of the cumulative effects of policy shocks provideevidence on their relative expansionary and contractionary effects. These estimates aresummarized in Table IV. Positive and statistically significant cumulative effects of expansionary shocks indicate an increase in real output growth. In contrast, a negative

cumulative response indicates reduction in real output growth despite expansionarypolicy shocks. Similarly, positive and statistically significant cumulative effects of contractionary shocks indicate a decrease in real output growth. In contrast, a negativecumulative response indicates an increase in real output growth despite contractionarypolicy shocks.

The difference between the cumulative effects of expansionary monetaryand government spending shocks, column (3), formalizes their relative effects onoutput growth. Output expansion is not significantly larger in the face of expansionarygovernment spending shocks compared to monetary shocks in any country. Outputgrowth is significantly larger in the face of expansionary monetary shocks comparedto government spending shocks in one out of 17 countries. The difference between thecumulative effects of contractionary monetary and government spending shocks

formalizes their relative effects on output growth. Output contraction is significantlylarger in the face of monetary shocks compared to government spending shocks ineight out of 17 countries.

A statistically significant difference between the cumulative effects during expansionsand contractions (Table IV) formalizes asymmetric real output growth in the face of government spending and monetary shocks. In column (7), the positive and statisticallysignificant difference indicates a higher rigidity of output adjustment to contractionaryrelative to expansionary government spending shocks in Ireland and Spain. There is no


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significant evidence of a larger output contraction relative to expansion in the face of government spending shocks. In column (8), output growth appears more responsive(less rigid) in the face of contractionary compared to expansionary monetary shocks inAustralia, Austria, Italy, Japan, The Netherlands, Norway, and the USA. Output

expansion exceeds contraction in the face of monetary shocks in Belgium, Spain, andthe UK.

Given asymmetry, the variability of policy shocks differentiates the relative effectson meal output growth during expansions and contractions. Based on cumulativeeffects, Table IV summarizes the contributions of government spending shocks, E ( Dy ) g , and monetary shocks, E ( Dy )m, to average real output growth, E ( Dy ). In column(9), the net contribution of government spending shocks is positive, increasing realoutput growth, on average, in the majority of countries (11 out of 17)[43]. The netcontribution of government spending shocks is negative to average real output growthin six countries[44]. The net contribution of monetary shocks is positive, increasingreal output growth in seven countries[45]. The net contribution of monetary shocks isnegative, decreasing real output growth, on average, in the majority of countries (10 outof 17)[46]. Output contraction dominates, therefore, expansion in the face of monetaryshocks in the majority of countries.

To summarize, the evidence indicates that the degreeof asymmetry is dependent on therelative flexibility of the nominal wage and price which is specific to conditions in laborand product markets within countries. Further, these conditions appear to vary with thetype of shock, monetary or government spending shocks, within countries. In general, theupward flexibility of price is in sharp contrast to downward rigidity in the face of monetary shocks. This is in contrast to the smaller inflationary effect and the largerdeflationary effect of government spending shocks on price. The evidence appears mixedconcerning the relative inflationary and deflationary effects of monetary and governmentspending shocks on the nominal wage. Nonetheless, the relative flexibility of the nominal

wage and price determines that government spending shocks have a net positivecontribution, increasing real wage growth, on average, in many countries. In contrast,monetary shocks have a net negative contribution, decreasing real wage growth, onaverage, in many countries. Given the small contractionary effect of government spendingshocks on output, these shocksincrease real outputgrowth, on average, in many countries.In contrast, the contractionary effect dominates the expansionary effect of monetaryshocks, decreasing real output growth on average in many countries.

5. Sources and implications of asymmetryApparently, asymmetry is more pronounced in the face of monetary shocks comparedto government spending shocks. Further, asymmetric price adjustment is crucial indifferentiating the asymmetric effects of monetary and government spending shocks.

5.1 Demand-side or supply-side asymmetry? Demand-side asymmetry is likely to establish a positive correlation between the relativeeffects of demand shocks on output, price, and the nominal wage. In contrast,supply-side asymmetry is likely to establish a negative correlation between asymmetryof the effects of demand shocks on output and their asymmetric effects on the nominalwage and/or price. Cross-country correlations shed some light on the source of asymmetry.

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Across countries, correlation coefficients between the asymmetric effects of government spending shocks on output,

P6 j¼0ðd pgj 2 d ngjÞ and that for price,P6

j¼0ða pgj 2 angjÞ and the nominal wage,P6

j¼0ðb pgj 2 bngjÞ are 20.057 and 0.15,respectively. The small correlation coefficients indicate that conditions on the demand

and supply sides of various economies do not produce systematic correlations betweenvariables relative adjustments to expansionary and contractionary governmentspending shocks.

The asymmetric effects of monetary shocks appear, however, largely dependent onasymmetric price adjustment across countries. This is evident by the significantnegative correlation, 20.67, between the asymmetric effects of monetary shocks onoutput,

P6 j¼0ðd pmj 2 d nmjÞ, and price,

P6 j¼0ða pmj 2 anmjÞ. In contrast, cross-country

correlation between the asymmetric effects of monetary shocks on output and that forthe nominal wage,

P x j¼0ðb pmj 2 bnmjÞwhile consistent with supply-side asymmetry,

20.15, is small in absolute magnitude.

5.2 The effects of policy shocks across countriesThe time-series evidence highlights important differences in the real and inflationaryeffects of monetary and government spending shocks within many countries.To complete the evidence, cross-section regressions will aim at illustrating howasymmetry differentiates the effects of monetary and government spending shocksacross countries. The results are summarized in Table V[47]. The left-hand side panelsummarizes cross-country variation in the face of government spending shocks.The right-hand side panel summarizes cross-country variation in the face of monetaryshocks.

The top portion of Table V presents the evidence in the face of expansionary shocksacross countries. Price inflation is generally moderate in the face of expansionarygovernment spending shocks in many countries. Across countries, lower price inflation

increases the expansionary effect of government spending shocks on output, as evidentby the negative and statistically significant coefficient in regression 1a. In regression2a, the flexibility of the nominal wage to adjust upward moderates, althoughinsignificantly, output expansion in the face of government spending shocks. Further,less price flexibility relative to nominal wage flexibility increases output expansion, asevident by the negative and statistically significant coefficient in regression 3a.Accordingly, an increase in real wage growth correlates with a larger output expansionin the face of government spending shocks, as evident by the positive and statisticallysignificant coefficient in regression 4a.

Prices are generally flexible in the face of expansionary monetary shocks in manycountries. Across countries, upward price flexibility moderates output expansion in theface of monetary shocks, as evident by the negative and statistically significant

coefficient in regression 1b. While nominal wage flexibility moderates theexpansionary effect of monetary shocks on real output, the difference, in regression2b, is not statistically significant across countries. Further, higher price flexibilityrelative to nominal wage flexibility moderates output expansion, as evident by thenegative and statistically significant coefficient in regression 3b. Accordingly,a decrease in real wage growth correlates with a smaller output expansion in theface of monetary shocks, as evident by the positive and statistically coefficient inregression 4b across countries.


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Reg. Dep. Var. Exp. Var. R 2

1aP6

j¼0d pgj ConstantP6

j¼0b pgj

0.0087 (0.15)2

0.38*

( 2

2.58) 0.312a

P6 j¼0d pgj Constant

P6 j¼0a pgj

0.023 (0.31) 20.046 ( 20.27) 0.005

3aP6


j¼0ðb pgj 2 a pgjÞ

20.053 ( 20.84) 20.44 * ( 22.61) 0.31

4aP6


j¼0c pgj

20.054 ( 20.86) 0.44 * (2.63) 0.32

5aP6

j¼0d ngj ConstantP6

j¼0bngj

20.057 ( 20.77) 20.43 * ( 21.83) 0.18

6aP6


j¼0angj

20.086 ( 21.09) 20.14 ( 20.75) 0.036

7aP

6 j¼0d ngj Constant

P6

j¼0ðbngj 2 angjÞ

20.098 ( 21.27) 20.12 ( 20.57) 0.021

8aP6


j¼0cngj

20.097 ( 21.26) 0.12 (0.51) 0.017

1bP6

j¼0d pmj ConstantP6

j¼0b pmj

0.52 * (2.52) 21.19 * ( 22.50) 0.29

2bP6


j¼0a pmj

0.33 * * (1.48) 20.36 ( 20.71) 0.032

3bP6


j¼0ðb pmj 2 a pmjÞ

0.34 * * (1.60) 20.68 * * ( 21.34) 0.11

4bP6


j¼0c pmj

0.34 * * (1.60) 0.69 * * (1.35) 0.11

5bP6

j¼0d nmj ConstantP6

j¼0bnmj

0.37 * (3.082) 20.89 * ( 22.99) 0.37

6bP6


j¼0anmj

0.53 * (3.14) 20.43 ( 21.06) 0.069

7bP6


j¼0ðbnmj 2 anmjÞ

0.26 * * (1.52) 20.56 * * ( 21.55) 0.14

8bP6


j¼0cnmj

0.28 * (1.80) 0.65 * (1.96) 0.20

Notes: a pgj

, angj

, a pmj

, anmj

approximate the inflationary and deflationary effects of governmentspending shocks and monetary shocks on price inflation for j ¼ 0,

. . .,6 in model (4); b pgj , bngj , b pmj , bnmj

approximate the inflationary and deflationary effects of government spending shocks and monetaryshocks on nominal wage inflation for j ¼ 0,. . .,6 in model (5); c pgj , cngj , c pmj , cnmj approximate the effectsof expansionary and contractionary shocks to government spending and the money supply on realwage growth for j ¼ 0,. . .,6 in model (6); d pgj , d ngj , d pmj , d nmj approximate the effects expansionary andcontractionary shocks to government spending and the money supply on real output growth for

j ¼ 0,. . .,6 in model (7); t -ratios are in parentheses; * and * * denote statistical significance at the fiveand ten percent levels

Table V.The effects of policyshocks across countries

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The bottom portion of Table V presents the evidence in the face of contractionaryshocks. Prices are generally flexible in the face of contractionary government spendingshocks in many countries. Across countries, downward price flexibility moderatesoutput contraction, as evident by the negative and statistically significant coefficient in

regression 5a. The downward flexibility of the nominal wage moderates outputcontraction in the face of government spending shocks, as evident by the negative,although statistically insignificant coefficient in regression 6a. The downwardflexibility of price relative to the nominal wage moderates output contraction, asevident by the negative, although statistically insignificant coefficient in regression 7a.Accordingly, a smaller reduction of the real wage correlates with a smaller outputcontraction in the face of government spending shocks, as evident by the positive,although insignificant, coefficient in regression 8a across countries.

Prices are generally rigid in the face of contractionary monetary shocks in manycountries. Across countries, downward price rigidity exacerbates output contraction inthe face of monetary shocks, as evident by the negative and statistically significant

coefficient in regression 5b. The downward flexibility of the nominal wage moderatesoutput contraction in the face of monetary shocks, as evident by the negative, althoughstatistically insignificant coefficient in regression 6b. Further, larger downwardflexibility of the nominal wage relative to price exacerbates output contraction, asevident by the negative and statistically significant coefficient in regression 7b.Accordingly, a larger reduction in real wage growth correlates with a larger outputcontraction in the face of monetary shocks, as evident by the positive and statisticallysignificant coefficient in regression 8b across countries.

It appears, therefore, that asymmetric price flexibility is an important factor indifferentiating economic performance in the face of monetary and governmentspending shocks across countries (Table VI). Higher price flexibility moderates output

Country s g s m

Australia 0.029 0.013Austria 0.046 0.024Belgium 0.12 0.02Canada 0.018 0.028Denmark 0.088 0.033Finland 0.06 0.025France 0.17 0.014Germany 0.072 0.009Ireland 0.12 0.032Italy 0.15 0.07

Japan 0.038 0.025

The Netherlands 0.086 0.025Norway 0.025 0.036Spain 0.11 0.02Sweden 0.00012 0.0043UK 0.022 0.024USA 0.010 0.012

Notes: s g and s m measure the standard deviation of the shocks to the growth of governmentspending and the money supply

Table VI.The variability of the

shocks to governmentspending and the money

supply


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government spending shocks have a net positive contribution, increasing real wagegrowth, on average, in many countries. In contrast, monetary shocks have a netnegative contribution, decreasing real wage growth, on average, in many countries.Further, price deflation moderates output contraction relative to expansion, increasing

real output growth, on average, in the face of government spending variability in manycountries. In contrast, downward price rigidity exacerbates output contraction relativeto expansion, decreasing real output growth, on average, in the face of monetaryvariability in many countries.

Cross-country correlations shed some light on the source of asymmetry. Asymmetryis more pronounced in the face of monetary shocks compared to government spendingshocks. Consistently, demand and supply conditions do not produce systematiccorrelations between variables’ relative adjustments to expansionary andcontractionary government spending shocks across countries. In contrast, theasymmetric effects of monetary shocks appear largely dependent on asymmetricprice adjustment in the product market. Conditions in the labor market appear lessimportant to supply-side asymmetry in the face of monetary shocks across countries.

Across countries, asymmetric price flexibility is an important factor indifferentiating economic performance in the face of monetary and governmentspending shocks. Higher price flexibility moderates output expansion and decreasesreal wage growth in the face of expansionary monetary shocks. Further, downwardprice rigidity reinforces output contraction and the reduction in real wage growth inthe face of contractionary monetary shocks. The combined effect establishes thatoutput contraction exceeds expansion, on average, in the face of monetary shocksacross countries. In addition, real wage reduction dominates growth, on average, in theface of monetary shocks across countries. In contrast, slower price inflation increasesoutput expansion and real wage growth in the face of expansionary governmentspending shocks. Further, downward price flexibility moderates output contraction

and the reduction in real wage growth in the face of contractionary governmentspending shocks. The combined effect establishes that output expansion exceedscontraction, on average, in the face of government spending shocks across countries.In addition, real wage growth exceeds, on average, reduction in the face of governmentspending shocks across countries.

Methodologically, the paper constitutes a further variation on the application of asymmetry. Its contribution lies in generalizing previous analysis through thedecomposition of demand shocks into fiscal and monetary components, and inmulti-country analysis. The results established extend the manner in which the relativeeffectiveness of fiscal and monetary policy may be appraised, and thereby aid thedesign of demand management policy.

For policy implications, the evidence establishes the desirability to minimize

monetary variability over time. Higher variability, along a kinked supply curve, islikely to exacerbate output contraction and price inflation, while decreasing real wagegrowth. Hence, growing the money supply along a steady path over time is moredesirable to anchor expectations and avoid the adverse effects of monetary variability.In contrast, fiscal policy provides stabilizing effects to counter inflation and stimulategrowth, while maintaining real wage growth. Variability of government spending is,therefore, desirable to maintain a steady path of the economy that maximizes realgrowth while containing inflation. Such results support the recent trends to give up


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monetary independence in the context of monetary unions and fixed exchange rateregimes. Nonetheless, prudent fiscal policy is necessary to ensure adequate financingand maintain the effectiveness of fiscal policy. The success of fiscal policy to stimulategrowth is crucial to ensure fiscal sustainability, without jeopardizing the potential of

private resources.

Notes

1. The debate concerning the effectiveness of fiscal and monetary policies in stabilizingeconomic conditions is an old topic. Monetarists have argued for the importance of monetarypolicy in determining economic conditions (Friedman, 1956). They argue, however, thataggressive monetary policy is likely to induce a wide range of results, although with a lagthat may interfere with its objectives. Accordingly, they advise the Fed to grow the moneysupply at a steady rate over time. In contrast, Keynesians, have argued for the effectivenessof fiscal policy. The effectiveness of monetary policy is likely to depend on conditions in thecredit market and the effect of credit availability on private spending (Tobin, 1947).Accordingly, conditions may arise that limit changes in the credit market or their effects on

private spending following changes in the money supply. Given these conditions, monetarypolicy may become ineffective in determining aggregate demand and, therefore, stabilizingthe economy during booms and recessions. Alternatively, Keynesians have advocated theneed for fiscal policy. The change in government spending guarantees timely changes inaggregate demand, as targeted by stabilization policies.

2. Given the limits on tax revenues and the political unpopularity of raising taxes, traditionalmethods to finance the increased government spending are either borrowing or monetizingthe budget deficit. In light of the inflationary consequences of the latter option, manygovernments have been heavily borrowing to finance the increased spending.

3. This explanation was advocated in view of the evidence of expansionary fiscal contractions,see, e.g. Giavazzi and Pagano (1990), and Alesina and Perotti (1995). For evidence of asymmetry in interest-rate adjustment to government spending shocks, see Kandil (2001).

4. See, for example, Barro (1989): “The substitution of a budget deficit for current taxes has noimpact on the aggregate demand for goods. In this sense, budget deficits and taxation haveequivalent effects on the economy-hence, the term “Ricardian equivalence theorem.” For acoherent theoretical illustration of the equivalence theorem, see Barro (1974).

5. For more details, see, for example, Feldstein (1976). Taxpayers may face binding liquidityconstraints if consumption absorbs disposable income entirely. With these constraints,households are likely to increase savings in anticipation of future tax liability. In contrast,households are constrained from increasing consumption (decreasing savings) inanticipation of future tax reduction.

6. Examples are models advocating the asymmetric effects of credit rationing policies, as inBernanke (1983). Jackman and Sutton (1982) set a similar argument by focusing on the effectof interest rate changes on spending. They report that as interest rates rise (in response, e.g. a

tight monetary policy), consumption spending falls the full amount as a result of the increasein debt payments. In contrast, a decrease in interest rates (in response, e.g. an expansionarymonetary policy) induce higher levels of spending, but by an amount less than the change inliabilities. Similarly, Bernacke and Gertler (1989) analyze the relation between changes in theinterest rate and investment demand. They find that large drops in investment are morelikely to occur than large increases.

7. For example, if consumers do not believe in the Federal Reserve’s ability to stimulatedemand through expansionary monetary policy, they continue to make pessimistic forecastsduring a recession. Consequently, lower interest rates may not provide a very strong

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incentive for consumers to increase spending during a recession. Likewise, firms may not beinclined to increase borrowing for investment in response to lower interest rate if they do notbelieve the economy will rebound from a recession. For some empirical evidence along thisline, see Gertler and Gilchrist (1992), Kam and Mohsin (2006) and Ramlogan (2005). Domac

and Kandil (2002) consider options to maximize the effectiveness of monetary policy usingdata for Germany.

8. See, for example, Gray (1978).

9. See, for example, Kandil (2002b). Implicit or explicit contractual wage negotiations mayestablish that nominal wage flexibility is asymmetric. Asymmetric nominal wage flexibilitymay be the result of institutional settings that differentiate wage and salary negotiations inthe upward and downward directions. During boom periods, cost of living adjustments maybe specified to guarantee workers an upward adjustment of wages to keep up with inflation.In contrast, firms may be reluctant to take aggressive measures towards adjusting nominalwages in the downward direction during recessionary periods. This is because the searchand training cost of hiring new workers to accommodate a future rise in demand mayactually exceed the perceived loss of retaining workers at wages that exceed the marginalphysical product of labor during recessionary periods. Alternatively, the asymmetric

flexibility of nominal wages may be an endogenous response to aggregate uncertainty.Models of the variety of Gray (1978) have emphasized the dependency of the degree of indexation on the variability of stochastic disturbances. In a situation where positive andnegative shocks are not equally variable, agents’ incentives for the optimal degree of indexation would be asymmetric.

10. See, for example, Ball et al. (1988).

11. See, for example, Ball and Mankiw (1994). Positive trend inflation plays a key role inintroducing asymmetries. Inflation causes firms’ relative prices to decline automaticallybetween adjustments. This requires greater adjustment of firms’ desired prices in the face of positive shocks compared to negative shocks. When a firm wants a lower relative price in theface of negative demand shocks, inflation does much of the work, decreasing the need to paythe menu costs to adjust prices. By contrast, a positive shock means that the firms’ relative

price rises while its actual price is falling, creating a large gap between desired and actualprices. As a result, positive shocks are more likely to induce a larger price adjustmentcompared to negative shocks.

12. To develop some evidence on the relative flexibility of the cyclical behavior of the nominalwage and price, an empirical model illustrates the asymmetric effects of governmentspending and monetary shocks on the real wage.

13. The neutrality of anticipated demand shifts on real output may be violated if nominalvariables do not adjust fully in anticipation of these shifts. Testing the validity of thishypothesis is beyond the scope of this investigation. Further, anticipated demand shifts areorthogonal, by construction, to unanticipated shifts. Accordingly, the effects of demandshocks are robust with respect to a modification that includes anticipated demand shifts inthe empirical model of real output.

14. Given the interest in studying asymmetry of demand shocks, the empirical specificationincludes the lags of these shocks to study asymmetry in variables’ adjustments over time.Due to the multiplier effect, shocks may persist in the economic system beyond agents’expectations.

15. Cointegration test results reject the hypothesis that the nonstationary variables in themodels, the anticipated components of the energy price, government spending and the moneysupply, are jointly cointegrated with the non-stationary dependent variables. In the absenceof a joint co-integrating vector, it is not possible to control for the long-run dynamics via anerror correction term in the empirical model.


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16. Other measures of supply-side shifts, e.g. productivity and technological shifts, are not

readily available across countries. Constructed measures are likely to be correlated with the

dependent variables, countering their usefulness for the paper’s analysis.

17. In that sense, government spending is a better measure of discretionary fiscal policy

compared to the budget deficit that may vary with automatic stabilizers. Net taxes increaseduring a boom and decrease during a recession.

18. Shocks impinging on the economic system may induce unexpected increase in government

spending or the money supply (e.g. the increase in government spending and monetary

easing following September 11, 2001.

19. Government spending is a discretionary measure of fiscal policy. Other measures, e.g.

government revenue and the primary surplus, are likely to vary endogenously with the

business cycle. Therefore, they are less useful for policy analysis.

20. The interest rate is an alternative measure of the money supply where monetary policy

follows a Taylor rule. Identifying the relevant interest rate cannot be established

systematically across countries. Hence, using a measure of the money supply is more

preferred to analyze monetary policy across countries.21. Anticipated variables are based on agents’ forecasts of domestic and external variables,

including the exchange rate. For details, see Appendix A.

22. By construction (Appendix A), anticipated variables are function of lagged dependent

variables. Hence, adjustment to anticipated variables captures persistence in dependent

variables.

23. Higher energy price decreases the demand for labor and the nominal wage. Concurrently,

higher energy price accelerates price inflation, prompting workers to negotiate higher wages.

The less elastic the demand for output, the larger the increase in price and the higher the

probability of a rise in the nominal wage in response to an increase in energy prices. That is,

the rise in the price level is likely to dominate the reduction in the nominal wage attributed to

the reduction in labor demand in this situation.

24. Anticipated values of price and wage inflation are function of their lagged values.

This eliminates the need for lagged dependent variables in equations (3) and (5).

25. The qualitative results and the paper’s conclusion are robust with respect to variation in the

lag length based on a formal test of the optimal lag length. These results are available upon

request.

26. Statistical significance is established at the five or ten percent levels. Detailed results are

available upon request.

27. This could be the result of the crowding out effect of government spending on private

spending, price control policies, or other determinants of price inflation that dominate the

effects of expansionary policy shocks. It is also possible that government spending has a

positive effect on the output supplied that dominates demand expansion.

28. Given asymmetry in the price response, the relative inflationary effects are not attributed todifferent size demand shifts in the face of monetary and fiscal shocks.

29. The sample includes both countries belonging to the common currency and countries having

single currency. Convergence of monetary policy in the former group in the context of the

monetary union is captured by structural break parameters in the forecast equation.

30. Mathematical expectation varies with the variability of policy shocks. The larger the

variability of the shocks, the larger the effect of asymmetry on trend price inflation.

Variability measures are provided in Appendix A.

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31. The largest reduction is evident in Ireland (on average quarterly price inflation decreases by

21.4 percent in the face of government spending shocks). The smallest reduction is evidentin Japan (on average quarterly price inflation decreases by 20.05 percent in the face of government spending shocks).

32. The largest increase is evident in Germany (on average quarterly price inflation increases by1.66 percent in the face of government spending shocks). The smallest increase is evident inSweden (on average quarterly price inflation increases by 0.012 percent in the face of government spending shocks).

33. The largest inflationary contribution is evident in Norway (on average quarterly priceinflation increases by 1 percent in the face of monetary shocks. The smallest inflationarycontribution is evident in Japan (on average quarterly price inflation increases by 0.052percent in the face of monetary shocks).

34. The largest deflationary contribution is evident in Italy (on average quarterly price inflationdecreases by 22.4 percent in the face of monetary shocks). The smallest deflationarycontribution is evident in Denmark (on average quarterly price inflation decreases by20.44percent in the face of monetary shocks).

35. The largest reduction is evident in France (on average quarterly nominal wage inflationdecreases by 21.3 percent in the face of government spending shocks). The smallestreduction is evident in Sweden (on average quarterly nominal wage inflation decreasesby 2 0.04 percent in the face of government spending shocks).

36. The largest increase is evident in Germany (on average quarterly nominal wage inflationincreases by 3.2 percent) in the face of government spending shocks. The smallest increase isevident in Australia (on average quarterly nominal wage inflation increases by 0.05 percent).In the case of Belgium, the effects of government spending shocks are symmetric on thenominal wage during expansions and contractions, as indicated by the net zero contribution.

37. The largest increase is evident in the UK (on average quarterly nominal wage inflationincreases by 0.74 percent in the face of monetary shocks). The smallest increase is evident inthe USA (on average quarterly nominal wage inflation increases by 0.026 percent in the face

of monetary shocks).

38. The largest reduction is evident in Italy (on average quarterly nominal wage inflationdecreases by23.2 percent in the face of monetary shocks). The smallest reduction is evidentin Canada (on average quarterly nominal wage inflation decreases by 20.015 percent in theface of monetary shocks).

39. The largest increase is in Germany (on average quarterly real wage growth increases by1.5 percent in the face of government spending shocks). The smallest increase is in Australia(on average quarterly real wage growth increases by 0.23 percent in the face of governmentspending shocks).

40. The largest reduction is evident in Italy (quarterly real wage growth decreases, on average,by 21.1 percent in the face of government spending shocks). The smallest reduction isevident in Sweden (on average quarterly real wage growth decreases by20.06 percent in the

face of government spending shocks). The symmetric effects of government spendingshocks on the real wage are consistent with a net zero contribution in Canada.

41. The largest reduction is evident in Sweden (on average quarterly real wage growth decreasesby 22.2 percent in the face of monetary shocks). The smallest reduction is evident inGermany (on average quarterly real wage growth decreases by 20.03 percent in the face of monetary shocks).

42. The largest increase is evident in Spain (on average quarterly real wage growth increases by0.48 percent in the face of monetary shocks). The smallest increase is evident in the UK


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(on average quarterly real wage growth increases by 0.12 percent in the face of monetaryshocks).

43. The largest increase is evident in Finland on average quarterly real output growth increasesby 1.4 percent in the face of government spending shocks). The smallest increase is evident

in Canada (on average quarterly real output growth increases by 0.009 percent in the face of government spending shocks).

44. The largest reduction is evident in France (on average quarterly real output growthdecreases by 21.2 percent in the face of government spending shocks). The smallestreduction is evident in The Netherlands, (on average quarterly real output growth decreasesby 20.04 percent in the face of government spending shocks).

45. The largest increase is evident in Spain (on average quarterly real output growth increasesby 2.2 percent in the face of monetary shocks). The smallest is evident in Germany(on average real output growth increases by 0.05 percent in the face of monetary shocks).

46. The largest reduction is evident in Norway (on average quarterly real output growthdecreases by22.7 percent in the face of monetary shocks). The smallest reduction is evidentin Japan (on average real output growth decreases by20.41 percent in the face of monetary

shocks).

47. The parameters in the cross-section regression are weighted by the inverse of the standarderror in the time-series regression.

48. This procedure follows the suggestion of Cover (1992).

References

Alesina, A. and Perotti, R. (1995), “The political economy of budget deficits”, Staff Papers, International Monetary Fund , Vol. 42, pp. 1-31.

Apergis, N. and Miller, S. (2005), “Money volatility and output volatility: any asymmetric effects?Evidence from conditional measures of volatility”, Journal of Economic Studies, Vol. 32

No. 6, pp. 511-23.Ball, L. and Mankiw, N.G. (1994), “Asymmetric price adjustment and economic fluctuations”,

Economic Journal .

Ball, L., Mankiw, N.G. and Romer, D. (1988), “The New Keynesian economics and theoutput-inflation trade-off”, Brookings Papers on Economic Acitivity, No. 1, pp. 1-82.

Barro, R.J. (1974), “Are government bonds net wealth?”, Journal of Political Economy, Vol. 84,pp. 1161-76.

Barro, R.J. (1989), “The neoclassical approach to fiscal policy”, in Barro, R.J. (Ed.), Modern Business Cycle Theory, Harvard University Press, Cambridge, MA.

Bernacke, B. and Gertler, M. (1989), “Agency cost, net worth, and business fluctuations”, American Economic Review, Vol. 79, pp. 14-31.

Bernanke, B. (1983), “Nonmonetary aspects of the financial crisis in the propogation of the greatdepression”, American Economic Review, pp. 257-76.

Cover, J.P. (1992), “Asymmetric effects of positive and negative money supply shocks”, Quarterly Journal of Economics, Vol. 107 No. 4, pp. 1261-82.

Dickey, D.A. and Fuller, W. (1981), “Likelihood ratio statistics for autoregressive gime series witha unit root”, Econometrica, Vol. 49, pp. 1057-72.

Domac, I. and Kandil, M. (2002), “On the performance and practicality of nominal GDP targetingin Germany”, Journal of Economic Studies, Vol. 29 No. 3, pp. 179-204.

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Dufour, J-M. (1982), “Generalized chow tests for structural change: a coordinate free approach”,

International Economic Review, Vol. 23, pp. 565-75.

Engle, R.R. (1982), “A general approach to lagrange multiplier model diagnostics”, Journal of Econometrics, Vol. 20, pp. 83-104.

Feldstein, M.S. (1976), “Perceived wealth in bonds and social security: a comment”, Journal of Political Economy, Vol. 84, pp. 331-6.

Friedman, M. (1956), “The quantity theory of money: a restatement”, in Friedman, M. (Ed.),

Studies in the Quantity Theory of Money, University of Chicago Press, Chicago, IL, pp. 3-21.

Gertler, M. and Gilchrist, S. (1992), Monetary Policy, Business Cycles, and the Behavior of Small Manufacturing Firms, NYU, Mimeo.

Giavazzi, F. and Pagano, M. (1990), “Can severe fiscal contraction be expansionary? Tales of twosmall European countries”, in Blanchard, O.J. and Fischer, S. (Eds), NBER

Macroeconomics Annual , MIT Press, Cambridge, MA.

Gray, J.A. (1978), “On indexation and contract length”, Journal of Political Economy, pp. 1-18.

Jackman, R. and Sutton, J. (1982), “Imperfect capital markets and the monetarist black box:

liquidity con-straints, inflation, and the asymmetric effects of interest rate policy”, Economic Journal , Vol. 92, pp. 108-28.

Kam, E. and Mohsin, M. (2006), “Monetary policy and endogenous time preference”, Journal of Economic Studies, Vol. 33 No. 1, pp. 52-67.

Kandil, M. (1995), “Asymmetric nominal flexibility and economic fluctuations”, Southern Economic Journal , pp. 674-95.

Kandil, M. (1996), “Sticky wage or sticky price? Analysis of the cyclical behavior of the realwage”, Southern Economic Journal , October, pp. 440-59.

Kandil, M. (1998), “Supply-side asymmetry and the non-neutrality of demand fluctuations”, Journal of Macroeconomics, Vol. 20 No. 4, pp. 785-810.

Kandil, M. (1999), “The asymmetric stabilizing effects of price flexibility: historical evidence and

implications”, Applied Economics, Vol. 31, pp. 825-39.

Kandil, M. (2001), “Asymmetry in the effects of US government spending shocks: evidence and

implications”, The, Quarterly Review of Economics and Finance, Vol. 41, pp. 137-65.

Kandil, M. (2002a), “Asymmetry in the effects of monetary and government spending shocks:contrasting evidence and implications”, Economic Inquiry, Vol. 40 No. 2, pp. 288-313.

Kandil, M. (2002b), “Asymmetry in economic fluctuations in the US economy: the pre-war and

the 1946-1991 periods compared”, International Economic Journal , Vol. 16 No. 1, pp. 21-42.

Karras, G. (1996a), “Are the output effects of monetary policy asymmetric? Evidence from a

sample of European countries”, Oxford Bulletin of Economics and Statistics, Vol. 58,pp. 267-78.

Karras, G. (1996b), “Why are the effects of money supply shocks asymmetric? Convex aggregate

supply or push on a string?”, Journal of Macroeconomics, Vol. 18, pp. 605-19.Miller, M.H., Skidetsky, R. and Weller, P. (1990), “Fear of deficit financing – is it rational?”, in

Dornbusch, R. and Draghi, M. (Eds), Public Debt Management: Theory and History,

Cambridge University Press, Cambridge, MA, pp. 293-310.

Nelson, C.R. and Plosser, C.I. (1982), “Trends and random walks in macroeconomic time series”,

Journal of Monetary Economics, Vol. 10, pp. 139-62.

Pagan, A. (1986), “Two stage and related estimators and their applications”, Review of EconomicStudies, Vol. 53, pp. 517-38.


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Ramlogan, C. (2005), “The transmission mechanism of monetary policy: evidence from theCaribbean”, Journal of Economic Studies, Vol. 31 No. 5, pp. 435-47.

Tobin, J. (1947), “Liquidity preference and monetary policy”, Review of Economics and Statistics,Vol. 29, pp. 124-31.

Further reading

Cover, J.P. and Van Hoose, D. (1993), “Asymmetric wage indexation”, unpublished manuscript,University of Alabama, Tuscaloosa, AL.

Evans, P. (1987), “Interest rates and expected future budget deficits in the United States”, Journal of Political Economy, Vol. 95, pp. 34-58.

Hubbard, R.G. and Kenneth, L.J. (1986), “Liquidity constraints, fiscal policy, and consumption”, Brookings Papers on Economic Activity, pp. 1-50.

Appendix 1. Econometric methodologyThe surprise terms that enter models (2) through (5) are unobservable, necessitating the

construction of empirical proxies before estimation can take place. Thus, the empirical modelsinclude equations that describe the process generating the growth in government spending, andthe money supply. The predictive values from these equations are the proxies for agents’expectations of the change in these variables.

Obtaining the proxy for agents’ forecasts follows the results of the endogeneity test suggestedby Engle (1982). Given the evidence of endogeneity, variables in the forecast equations are basedon the results of a formal causality test.

Agents’ forecast of the growth in government spending and the money supply isapproximated using four lags of the change in the short-term interest rate and four lags of thechange in the log value of real output, the price level, the interest rate, the energy price,government spending, the money supply, and the exchange rate. The exchange rate is measuredby the real effective exchange rate, which accounts for interdependent effects between countries.Insignificant, parameters indicate the exogeneity of policy shifts with respect to past values of a

specific variable.Countries under investigation may have experienced major institutional and structural

changes, including the relaxation of capital controls over time and convergence of monetary andfiscal policies. Having tested for structural break, the forecast equations include dummyvariables, as necessary. Subsequently, there is no evidence of structural break in the estimatedreduced-form models.

Surprises that enter the empirical models are then formed by subtracting agents’ forecastsfrom the actual growth in each variable. The residuals of forecast equations represent policyshocks, which are serially uncorrelated and orthogonal to variables in the forecast equations.The results are robust with respect to variation in variables or the lag length in the forecastequations.

The positive and negative components of government spending or monetary shocks aredefined for joint estimation. Following the suggestions of Cover (1992), as follows:

negd t ¼ 21

2{absðdst Þ2 dst }

posd t ¼1

2{absðdstÞ þ dst } d ¼ g ; m

where gst is the shock to the growth of government spending, as specified above, and neg g t andpos g t are its negative and positive components. Similarly, mst is the shock to the growth of money supply and negmt and posmt are its positive and negative components.

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The energy price is exogenous according to the results of the test suggested by Engle (1982).Obtaining a proxy for ex-ante forecast of the energy price is complicated by the assumption thatthe generating process experienced a structural change between 1973 and 1974. This assumptionis suggested by the results of a formal test in Dufour (1982). For both the period 1960.I-1973.IV

and the period 1974.1-2000.IV, the generating process is modeled as a fourth-orderautoregressive process. The proxy for energy price surprises is then formed by subtractingthese forecasts from the actual change in the energy price.

Where test results support structural break, dummy variables are included in the equationsdescribing agents’ forecasts of other variables. Upon accounting for these dummy variables,testing for structural break in the estimated empirical models proved insignificant.

Subtracting the above forecasts from the actual change in the variable results in surprisesthat enter the empirical models. In order to obtain efficient estimates and ensure correctinferences (i.e. to obtain consistent variance estimates), the empirical models in (2) through (5) areestimated jointly with the equations that determine proxy variables following the suggestions inPagan (1986) using 3SLS. The instruments list for estimation includes four lags of the change inthe interest rate and four lags of the change in the log value of real output, the price level, thenominal wage, the exchange rate, government spending, and the money supply as well as the

change in current and four lags of the log value of the energy price.The results of Engle’s (1982) test for serial correlation in simultaneous-equation models areconsistent with the presence of fourth-order autoregressive errors in some models. Havingaccounted for the endogeneity of right-hand side variables, it is assumed that the error termfollows an AR (4) process. To filter out serial correlation, the estimated mode is transformedthrough the filter ð12 r 1 L

12 r 2 L

22 r 3 L

32 r 4 L

4Þ where r i are the estimates of the serialcorrelation parameters and L i are the lag operators such that L i X t ¼ X t 2 i .The estimated residualsfrom the transformed models have zero mean and are serially independent.

To calculate E( pos g ) and E( neg g ) in equation (6), government spending shocks, gs, areassumed to be normally distributed with mean zero and variance s2

g [48]. Accordingly:

E ðpos g Þ ¼

Z 1

0

gsf ð gsÞdgs ¼ s g =ð2p Þ0:5< 0:399s g ;

E ðneg g Þ ¼ 2s g =ð2p Þ0:5< 20:399s g

To calculate E( posm ) and E (negm ) in equation (7), monetary shocks, ms, are assumed to benormally distributed with mean zero and variance s2

m. Accordingly:

E ðposmÞ < 0:399s m;

E ðnegmÞ < 20:399s m

Appendix 2. Data sources

(1) Real output . Index of industrial output. Generally, the coverage of this index comprisesmining, quarrying, manufacturing, electricity, gas, and water according to the UNInternational Standard Industrial Classification (ISIC).

(2) Price level . The consumer price index.

(3) Nominal wage. Index of the wage rate per worker employed in the industrial sector perspecified time period.

(4) Money stock. The sum of currency outside banks and private sector demand and timedeposits.


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(5) Short-term interest rate. Representatives of short-term market rates for the variouscountries, i.e. rates at which short-term borrowing are affected between financialinstitutions or rates at which short-term government paper is issued or traded in themarket.

(6) Government spending . All payments by government.(7) Aggregate demand . Nominal values of GNP/GDP.

(8) The energy price. The price of Venezuelan petroleum.

(9) Exchange rate. Real effective exchange rate.

Sources: All data are taken from the International Financial Statistics, available on tapes fromthe International Monetary Fund, Washington, DC

Corresponding authorMagda Kandil can be contacted at: [email protected]

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