1 Introduction
The long-standing debate among economists about the effectiveness of fiscal policy as a counter-cyclical tool has spawned a large literature about the size of fiscal multipliers. Recent interest has been driven by the fiscal stimulus programs put in place in many countries as a response to the global financial crisis, and the fiscal consolidations that have followed. The arguments in favour of activist fiscal policy emphasise the fact that fiscal policy may be particularly effective during recessions when monetary policy can no longer be used effectively to increase aggregate demand (Eggerston and Krugman, 2012; Auerbach and Gorodnichenko, 2012). The opponents of this view, on the other hand, argue that the stabilisation effect is unlikely to materialise as it can be undercut by the expectations of rational agents who observe the government's policy process (eg, Barro, 2009).
Theoretical considerations aside, the cross-country evidence from previous empirical studies indicate a lack of consensus on the likely effects of fiscal policy shocks on the economy (see Caprioli and Momigliano, 2011 for a review). A major challenge in this regard is to be able to correctly identify the changes in current policy variables that are attributable to actual policies, rather than to endogenous responses to economic conditions. Possible delays in legislation, the lags in actual implementation of the policies and the time to recognise that there is actually a need for stabilisation in the first place are also amongst the problems encountered in empirical analysis of fiscal policy.
The focus of this paper is the estimation of a five-equation structural VAR (SVAR) model for New Zealand to investigate the effects of unexpected discretionary fiscal policies on New Zealand's economic activity. The paper builds on the previous work by Claus et al. (2006) who examine the effects of fiscal policy on New Zealand GDP using the popular 3-equation framework proposed by Blanchard and Perotti (2002).
There has been an increase over the last decade in the number of studies that use the structural VAR approach to investigate the effects of fiscal policy shocks on macroeconomic variables (Blanchard and Perotti, 2002; Perotti, 2005; Giordano et al., 2007; Claus et al., 2006; Caldara and Kamps, 2008; Fatas and Mihov, 2001). Structural interpretations of VAR models require additional identifying assumptions that must be motivated based on institutional knowledge or economic theory. There have been several suggestions to improve the usefulness of these models for fiscal policy analysis.
A notable suggestion in this respect is given by Favero and Giavazzi (2007), hereafter FG, who argue that the majority of fiscal VAR studies rely on potentially misspecified models as they fail to include any feedback from the level of debt, a stock variable, to the variables that enter the government's intertemporal budget constraint (hereafter IGBC). Using US data covering the period 1960:1-2006:2, they show that the misspecification arises since a fiscal shock eventually puts a constraint on the path of taxes and spending in the future that the VAR is unable to respond to. They stress that the bias will be particularly evident in periods when there is a strong relationship between the government's balances and the debt-to-GDP ratio. Similar concerns are also highlighted by Chung and Leeper (2007).
On a more general and technical note, Pagan et al. (2008) emphasise the possible pitfalls of excluding a stock variable in a VAR specification. They show that such an omission introduces non-invertible moving average terms into the model, meaning that the structural VAR (SVAR) representation of the system fails to exist.
Following these considerations, we extend the model used in Claus et al. (2006) along several directions. Using the methodology outlined in FG, we allow for the possibility that taxes, spending and interest rates might respond to the level of debt over time. This is implemented by enriching the model dynamics to include two additional variables: the long-term interest rates and inflation as well as including the government’s intertemporal budget constraint as an identity. Additionally, we extend the dataset up to the second quarter of 2010 to allow for a more up-to-date analysis of the effects of fiscal policy on the New Zealand economy.
The results show that the fiscal multipliers from changes in government spending in New Zealand appear to be positive but small in the short-run. The impact multiplier is estimated to be about 0.26 which implies that a 1 percent of GDP change to government expenditure increases GDP by 0.26 percent. The sign of the short-run effects of tax changes is less clear cut, consistent with the puzzle outlined in Fielding et al. (2011), but the magnitude of the effect on GDP is similarly modest. Tax increases are found to drag economic activity in the medium term.The responses of output to both types of fiscal shocks are largely insignificant. The results show that a fiscal expansion leads to a statistically significant increase in the long-term interest rate which results in crowding-out in the medium and long-term. The corresponding effect on inflation is modest which implicitly implies that monetary policy moderates the inflationary effects.
Past fiscal policy is analysed through a historical decomposition of the shocks in the model. This suggests that discretionary fiscal policy has had a generally pro-cyclical impact on GDP over 1998 to 2010, and a material impact on long-term interest rates.
The remainder of the paper is organised as follows. Section 2 discusses the rationale for including the inter-temporal government budget constraint. Section 3 describes the model specification and the data descriptions. Section 4 reports the dynamic effects of shocks to fiscal and other macroeconomic variables in the model. Section 5 analyses the effects of fiscal policy on New Zealand's business cycle. Section 6 reports the results of various sensitivity analyses conducted for checking the robustness of the model and Section 7 concludes.
