On the Identification of Fiscal Policy Behavior

Bing Li ()
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Bing Li: Indiana University Bloomington

No 2008-026, CAEPR Working Papers from Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington

Abstract: In the current literature, fiscal policy is usually characterized by a singleequation rule, in which primary surplus is generally defined as a function of lagged government debt and other controlled variables. To apply Ordinary Least Squares (OLS) method on the single-equation rule has been one of the common approaches to identify fiscal policy behavior. From the rational expectations general equilibrium perspective, this paper illustrates that lagged government debt is generally endogenous and the OLS approach suffers from simultaneity bias. Consequently, the OLS-based identification of fical policy behavior is unreliable. As a solution, we apply the Generalized Method of Moments (GMM) for estimation and inference. Monte Carlo experiments demonstrate that GMM provides more reliable results than OLS in terms of accuracy of the estimator, size and power. In short, people should be cautious of the existing OLS-based identification results of fiscal policy behavior and the empirical researchers should not consider OLS regression as a reliable tool when trying to identify fiscal policy behavior in the future.

JEL-codes: C12 C13 E63 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2009-03
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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