Fiscal Policy, Interest Rates, and Output: Equilibrium-Correction Dynamics in the US Economy

Hans-Martin Krolzig and Isaac Sserwanja

VfS Annual Conference 2015 (Muenster): Economic Development - Theory and Policy from Verein für Socialpolitik / German Economic Association

Abstract: Joint modelling of fiscal and monetary policies should elucidate on their interaction. We construct an eight-dimensional parsimonious structural vector equilibrium correction model (PSVECM) of the US macro economy over the last five decades. The fiscal deficit is found to be one of the five cointegration vectors, constraining fiscal policy in the long run. In contrast, the share of the government sector is found not to be mean reverting. To overcome the common problem of ad-hoc assumptions regarding the direction of instantaneous causality, we use graph-theoretical methods to identify the causal structure of the model from the data. Model reduction procedures allow to control for the course-of-dimensionality inhibiting such high-dimensional vector autoregressive systems. Impulse-response analysis of the parsimonious system facilitated the precise measurement of the dynamic Keynesian fiscal multiplier, where we distinguish between deficit-spending and balanced-budget government spending shocks (as in the so-called Haavelmo, 1945, theorem). Our estimates of the long-run multiplier are 1.62 in case of the bond-financed and 1.77 in case of the tax-financed spending shock, with both being significant greater than one at a 95\% confidence level. Monetary policy is neutral is the long-run but have permanent effects on the level of output. Increasing the federal funds rate by a percentage point is followed by falling tax revenues while government spending is largely unchanged, thus inflating the fiscal deficit in the short- and medium run.

JEL-codes: C32 E63 H62 (search for similar items in EconPapers)
Date: 2015
New Economics Papers: this item is included in nep-mac
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